Something we observe again and again is that the rules that usually apply in middle-class society simply don’t work in investing. Try hard? You’d be better off not trying at all. Be smarter than the rest? Actually, acknowledging how ignorant you are would stand you in better stead.
What about aiming high? Well, it might help you climb the career ladder. But, as JOACHIM KLEMENT explains, it probably won’t give you an edge as an investor. In fact new research suggests that the bigger the returns you aim for, the lower the returns you actually receive are likely to be.
I have been on the receiving end of so many management goal-setting exercises, my eyes glaze over whenever I see another CEO tout aspirational targets for companies in their earnings calls. Don’t get me wrong, goals are important to have and they should be stretch goals. A goal that is easily achievable isn’t motivating. But a goal that is too much of a stretch or too audacious (have you ever been subject of the BHAG, the Big Hairy Audacious Goal?) is counterproductive and can destroy performance.
How ambitious should investors be?
Let’s take a look at the evidence from investors. Investors tend to have return goals that are way too high to be realistically achievable in the long run. A study from the Catholic University in Louvain, Belgium, looked at the trading accounts and stated return goals of more than 4,000 retail investors between 2008 and 2012.
About one third of these investors had a target return of 8% or more above inflation. Assuming a 2% inflation rate, that amounts to more than 10% average nominal returns. Another 41% had target returns of 5% to 7% above inflation. Given that a realistic assumption for the equity risk premium above inflation is somewhere around 3% to 7%, this means that three out of four retail investors try to achieve returns that can only be achieved with pure equity portfolios or riskier propositions. And if you think that this is just a reflection of the heavy losses, investors occurred in 2008 at the beginning of the study, then know that a 2016 study by Natixis of investors from 22 countries came up with an average required return of 9.5% above inflation. On average!
The higher they aimed, the worse they did
What the research found was that investors with a higher target return did miss their targets by a wider margin than investors with average target returns. And they did worse in terms of total return achieved. The group with the highest return targets did worse from 2008 to 2012 than investors with more moderate return targets.
In a backtest, the researchers also showed that in the bull market before the crisis from 2006 to 2007, the performance of the more ambitious retail investors lagged the performance of less ambitious investors even more.
The danger of falling behind
Another study amongst CEOs of companies shows why more ambitious goals may lead to lower performance. Looking at the performance incentives of CEOs of the 750 largest US companies from 1998 to 2017 they found that CEOs on average stand to earn c. $4.2m more per year if they end up in the top 10% of their peer group. Of course, everyone wants to be in the top 10%, so CEOs constantly are compared to their peers. It turns out that if CEOs fall behind their peers, they crank up the risk of their business and financing activities.
Relative to the best performing CEO in the peer group the worst performing CEO increases financial leverage, R&D spending and restructure the business to such an extent that stock price volatility increases in the aftermath by 18 percentage points and ROA volatility increases by 31 percentage points. This effect gets even more pronounced the closer to a potential payout of stock options the CEO gets. Unfortunately, that higher risk doesn’t pay off in general, so investors are typically left with more volatile but lower performing companies as a result of CEOs trying to meet stretch goals.
So, the next time, some management guru talks about the BHAG of your company, just call BS and throw them out of the room. Unless of course it is your CEO, in which case, smile, nod and ignore the CEO the moment you leave the room. Both you and your company will be better off for it.
JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.
Joachim is a regular contributor to TEBI. Here are some of his most recent articles:
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