Have you made a good investment?
Often when we speak to clients, friends, family or really anyone who has made investments and we ask them if it was a good investment they often come back with “Oh yes, its making money.” We’ve never quite understood what this meant, as “making money” is not difficult – even the safest investment available to you (say US Treasury or Singapore Government bonds) will make money over time. So certainly a simple positive return cannot be one’s threshold to deem an investment “good”. So how do you determine what is a “good” investment? Our answer – a good investment is one that has outperformed its relevant benchmark for the period of time you were invested in it[1],[2].
When you invest you are allocating capital
Anyone who invests money must realize that they are first and foremost allocators of capital. Capital, or your money in this case, can be deployed in a variety of “projects” or asset classes; Stocks, bonds, commodities, real-state, etc. Whatever your chosen asset class, you must understand that there is always a choice between two “projects”, the investment you choose and the relevant benchmark. The benchmark differs between asset classes or sometimes even region. For example, investing in large cap US stocks? You might use the S&P 500. Buying units in Mapletree Commercial Trust in Singapore you might use the FSTE ST Real Estate Investment Trust Index. The appropriate benchmark for an asset (or a portfolio) is always up for debate, but the exact benchmark is less important, what’s more important is that you select one before you make your investment. Typically we recommend an investable benchmark (for example you can replicate the S&P 500 returns by investing in Vangaurd’s S&P 500 ETF).
Why its important to use a Benchmark
Using a benchmark is important (especially an investible one) because as a capital allocator it is your lowest-effort alternative to the investment you are considering. For example, if you wanted to gain equity exposure you would have two choices 1) The High-Effort Project: Find a stock (or number of stocks) which you think have a good business, research their fundamentals, understand management, try and value it, keep up with earnings reports, etc. or 2) The Low-Effort Project: invest in the Vangaurd Total World Stock ETF (which tracks the MSCI ACWI Index), which has a very low cost (.09%) and you have to do no research into each of the underlying stocks (it holds over 8,162). All you have to know is that if world equity markets go up, so will your investment.
If you decide to go with Project 1 you must always realize that Project 2 is your very real alternative and much less strenuous path. Thus for Project 1 to be worth it, it has to significantly outperform[3] Project 2 during the time you were invested. Because if it doesn’t, you’ve spent a lot of time and effort, and yet earned less than you could have doing almost no work.
Small differences can make a huge difference overtime
Imagine you decided to go with Project 1 (High-effort) and over a 10 year period it gave you a return of 6% annualized. You might think – hey that’s not too bad. But then you observed that during this period Project 2 (Low-Effort) returned 8%. You might still think – again, not too shabby, only a 2% difference. However compound interest is hugely powerful, and that 2% annualized difference over 10 years results in an additional 37 cents for every dollar invested. Means for every $10,000 you invested, the Low-Effort project would return to you an additional $3,700.
Return Comparison between Projects
Patience is required, but how much is up to you
Now, it’s very common for an investment to take some time to start outperforming a benchmark, and for that patience is required. Just because your investment hasn’t outperformed its benchmark within the first month or six is no reason to exit it. How long you hold an investment is more of an art than a science, but at every point you re-evaluate your investment you must compare it to how well its done against its benchmark and if it has done better ask yourself – will it continue to do better? Or if it has not done better ask yourself – will it start to do better? By allowing your capital to be invested in a sub-optimal project (over extended periods of time) you’re not doing your job as a capital allocator.
In Conclusion
A good investment is an outperforming one. So anytime you allocate capital you’ve decided to choose a project over all others available to you, including investing in the benchmark (as its typically the most straightforward/low-effort project you can choose). So to be faithful to that capital, you must always consider the alternatives to your choice and ensure that you have made the right one, because sticking with the wrong choice can result in significant opportunity cost and a lot of effort not well spent.
[1] While concepts like sharpe ratios are important, we typically don’t see volatility as a risk in itself.
[2] Assuming like for like (i.e both the benchmark and asset have equivalent amounts of leverage, preferably zero, at the security level).
[3] We believe outperformance should be at minimum 2-3% annualized, but the great Benjamin Graham said you should target at least 5%