June 20, 2013
End-Period Dominance – A Behavioral Finance Trap to Avoid
Since the beginning of time, humans have been investing, and since then, we have been trying to perfect the system we use to measure the progress of our efforts. Early humans could only invest their time and sweat equity, and usually, it was used to determine how to meet some daily end. For example, the most optimal time to draw water or the means used to chase down and slaughter a wild animal in the field to feed their families. Unfortunately, no mechanism was available to compound their efforts from one day to the next, and the measurement of success was pretty simple: Did you eat or starve? Undoubtedly, as we have evolved, we have advanced technologically. Specifically, the investment marketplace has become exponentially better at its ability to measure performance across the globe.
Human behavior and its unpredictability have remained one of the only constants on Earth. It marvels me that no amount of progress can derail our erratic nature. The behavioral finance phenomenon of End-Period Dominance is a theory that states that your investment returns are dominated by the end date that you choose to evaluate performance. This phenomenon includes evaluating manager performance, asset classes or performance at the total-portfolio level. A solid investment program that consists of a disciplined, logical investment process can certainly vary from the stated policy return target at any given time. Imagine how dramatically different investment performance would look if you evaluated results in June 2009 and June 2013. The former is immediately after the worst market downturn since the Great Depression, the latter is in the midst of one of the greatest bull markets of our lifetime. Was your investment program an abject failure in 2009 and a success in 2013? I’d say the answer to that question is—well, it depends.
How was your portfolio allocated in 2008 as value deteriorated, and conversely, how did you reposition your portfolio in 2009 on the way up—and why? Investment skill or the lack thereof cannot be accurately measured at a point in time by simply using performance returns. The investment process that is employed to make those critical decisions is among the most important of any decision you will make. The process is just as important as the performance that it bears; in fact, I would argue that the investment process is even more important than is an isolated superior performance return. Great returns without a sound, disciplined process are just about as good as a hole-in-one: You certainly can’t pass off that stroke of luck as your skillful, accurate and consistent driving and putting prowess. Similarly, mediocre performance coupled with a sound, logical and disciplined investment process is akin to a stellar golfer who simply has an off-day. Whether you are a golfer or a professional investor, you are making a judgment on the best set of probabilities for the best possible outcome. Sometimes, as we golfers know, the ball just doesn’t go in the hole. But if we can get it close to the hole, we can still accomplish our mission and objectives with far less risk than the investor relying on the random event of a hole-in-one to score.
As prudent investors, we must be careful to not fall into typical behavioral finance traps. End-Period Dominance can skew a well-meaning fiduciary’s perception of what investment success truly is for a family or an organization. Every investor has a different philosophy on investing, but one characteristic that any successful philosophy must have in common is a long-term orientation. I can’t tell you how many times I have spoken with investors who claim to be long-term-oriented but who insist on focusing on quarterly performance manager by manager – I digress, that is another topic to blog about.
As global markets, economies, and governments become more volatile and complex, performance measurement and defining success have become even more difficult for governing fiduciaries and their constituencies. Our nation's Governing Fiduciaries are an interestingly diverse group. They are family members, or community leaders with varying levels and fields of professional expertise that have been recognized for their dedication to one or a number noble causes who have demonstrated their fiduciary qualifications, and have exercised sound judgment. Since few governing fiduciaries are also investment professionals, it is incumbent upon the industry professionals operating in a conflict free model to advocate their interest in the global marketplace. A Chief Investment Officer helps solve this problem. One of our main goals is to educate and assist fiduciaries in evaluating investment performance and program success. Defining success is critical when gauging the ability to measure it. At Hirtle Callaghan, we appreciate that every client’s mission, goals and objectives are unique. Investment program success should not be defined in terms of indexes or peer group rankings. The End Period Dominance phenomenon can certainly skew actual performance (positively or negative) in relation to indexes and peers. Indexes are unmanaged and we are trying to beat them right? Individually, peers are in as many different circumstances and investment strategies as there are offerings. Rather, we should look inward to assess whether our organization has an investment program that is well managed and employs a sound investment process that helps the organization meets it’s the goals. Ultimately, this will lead to a fair and accurate assessment of your ability to continue the noble work you set out to accomplish.
Donald J. Bird, CFP®
Don is an Investment Officer with Hirtle Callaghan and has worked with the firm’s institutional clients in the Southwest U.S. for six years. Prior to joining Hirtle Callaghan in 2007, he worked with The Vanguard Group as a Registered Representative advising high net worth clients on investment decisions and retirement planning. Don is a Certified Financial Planner™ professional (CFP®) and he earned a B.B.A. from the Fox School of Business at Temple University and an M.B.A. from the LaSalle University School of Business. He also holds Series 65 and Series 3 licenses.