(3/26/2007) Using the broader market returns as your investment benchmark is Savvy Investing
Article by Sam Mishra, MBA (MIT Sloan)
When I was a student in MIT Sloan, I remember asking a Wall Street money manager holding an information session as to why investors should invest in mutual funds, given the fact that 75% of funds trailed the market? This was back in early 2000, when the markets were at the top of the world, and Wall Street money-managers were like little gods. The answer the executive gave is endemic of the problems that plague the whole Wall Street money community to this day: "Well, we have our own benchmark within the mutual fund industry. As per the latest data, only 65% of the funds trail the bench-mark. So, 1 out of 3 money managers is actually beating the benchmark."
I immediately wanted to react back, but had to keep quiet, considering the fact that many of my class-mates were trying to get a job with the firm the Wall Street executive was representing. But who was he kidding? It was clear that the industry deliberately set a bench-mark which trailed the markets. If only 25% of funds averaged better returns than the markets (read S&P 500 returns); and 10% more, or 35% did better then the bench-mark, clearly the bench-mark was underperforming the markets, accounting for these 10% of funds which did better than the benchmark but worse than the market.
Wall street is back on top again, and analysts, money managers, journalists like the ones in Barrons and Wall Street Journal, and TV anchors like the ones in NPR's Nightly Business Report reign supreme. And they tout double digit gains for everything ranging from a particular stock to an ETF (exchange traded fund) to a Mutual Fund. And when they do that, what is frustrating is their lack of reference to the market returns, while touting a stock or mutual fund. Let me elaborate.
In the recent Barrons dated March 26, 2007, a certain writer touted readers to buy Starbucks, stating that the stock was once $40, now it is $31, and the readers should buy the stock, because it will go back up to $40 plus in the next 12 months. He provided lots of facts, ranging from how Starbucks was doing better than Wal-Mart in terms of branding overseas to the company management asserting 20% annual growth in revenue and earnings for the next 3 to 5 years.
The only fact I liked was the management asserting 20% annual growth for the next 3 to 5 years. So, over the next 3 to 5 years, the stock should perform equally well. But does that mean it will do the same in the next 12 months? For example, we are in the middle of a correction right now. If broader markets indeed correct 10% to 15% and we have an S&P 500 return of only 5% in the next 12 months, how the Starbucks stock will behave will be different from how it will behave if the broader markets returned 10% instead of 5%. And if the broader markets stay flat or go down 5% in the next twelve months because we might have a GDP growth recession, will the touted Starbucks stock still return the marketed 30% gains in the next 12 months? Probably not!
I give the above example, not because I don't like the Starbucks stock. In fact, I do, and the stock will do well in the next 3 to 5 years, considering its growth prospects, its exposure to the Global Economy as opposed to just selling caffeine domestically, the positive outlook of the management for the next 3 to 5 years, and the addictive nature of caffeine. So, it is reasonable to assume this stock growing at a rate of 20% annually for the next 3 to 5 years, on the average. But no one can predict what will happen to the broader markets in the next 12 months, or for that matter, to the Starbucks stock. If the markets go for a steep decline in the next 12 months, the Starbucks stock may not hit $40, or may not stay at $40, if it hits this touted 12 month target price!
In other words, it is great folly to predict stock price growths for a 12 month time period, especially considering the current market volatility. But that is what TV anchors keep doing all the time. When the Nightly Business Report has a guest who recommended stocks six months ago and is back again for that precious TV air-time, the venerable Paul Kangas of NPR always shows how the stock did in the six month / one-year period by comparing the prices six months / one-year ago to the current prices. This is insane. These anchors should be monitoring stock price returns for a longer time period --- 5 to 10 years, instead of 3 to 6 months. And they will only do that if these Wall Street executives who show up with their sage advice provide a five to ten year outlook, not a 6 to 12 month one!
Essentially, I am trying to say a couple of simple things here. First, don't fall for the cock-a-bull industry benchmarks of the mutual fund industry, since these are set to deliberately trail the markets. These money managers are more interested in their management fees, and that is why they set bench-marks which make them look prettier than they actually are. Second, always have the broader S&P 500 returns as your benchmark, and that too, for a time period way longer than 12 months. One will do well with a 5 to 10 year horizon; or a 3 to 5 year, at the minimum. Anything shorter will be speculation, and not investing. As per one body of research, from 1926 to 2002, the markets returned 10.7% per annum, or adjusting for an average inflation rate of 3% per year, the markets returned 7.7% per year. So, if you invest in an equity for ten years, and it gives you a return of 10.7% or more per year, you will beat the markets, and 3 out of 4 professional money managers!
So, should you buy that Starbucks stock because it will go back to 40 and beyond? Absolutely, if you have a broader 3 to 5 year time-frame in mind. But if you bought the Starbucks (or your favorite stock which is being touted to go through the roof in the next 12 months) stock thinking it will go up by 30% in the next 12 months, you might be negatively surprised if the economy goes for a hard-landing in the next 12 months. Don't you deserve to free yourself from the clutches of these average joe stock-market analysts, and print / TV journalists? If you think you do, please have the historic stock market returns of 10.7% as your bench-mark, and please invest, keeping in mind a longer time horizon five to ten years, and not 6 to 12 months!
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