Overview – You’re Only as Good (Or Bad) As What’s Around You
When trying to ascertain the quality of a product, how do you usually go about doing that?
Perhaps you do some research to try and learn as much about the product as possible, maybe you look at a variety of different reviews, or perhaps you ask your friends who own the product what their experience with it is like. Even if you did none of these things, chances are you at least compared it to other options available to you.
Compared to the alternatives, how does your preferred choice hold up? You may feel that the product you want is vastly superior to the other choices, but you won’t know for certain unless you take the time to make some comparisons.
In investing, almost everything is relative. Your portfolio’s performance, the quality of your analytical work, and the quality of your investments are only as good as what you compare them to. This may sound pessimistic, but comparisons are everywhere in investing – it’s only a matter of time before one needs to be made.
If comparisons are inevitable, then investors should know how to make good ones.
The Importance of Making Fair Comparisons
Before we continue, it’s important to first clarify that not all comparisons are equal. As an investor, making comparisons between two completely disparate elements not only skews your perception of reality, but may also lead to some unintentional emotional consequences as well.
Perhaps you’ve heard of the phrase “comparing apples to oranges”, and that an effective comparison is one that’s performed on an “apples to apples” basis. Comparisons are meaningless if the items being compared vary greatly from one another.
As an investor, you’re only doing yourself a major disservice by making grossly unfair comparisons.
Say you started investing exactly one year ago, and you want to compare how you’re doing relative to other investors. So, you compare your performance to someone who has over 20 years of experience and manages a multi-million dollar portfolio.
Clearly, this comparison is very unfair. You, a new investor, have chosen to compare your performance to someone who has vastly more experience than you and maintains a significantly larger portfolio.
After noticing how large the gap is between you and this 20-year veteran, chances are you’ll only end up feeling discouraged to continue investing or make very irresponsible decisions to try and emulate the portfolio they currently have. A portfolio composition for someone who’s been investing for several years doesn’t necessarily make sense for someone just starting out.
Now, imagine you compare your performance to that of other investors who have a similar level of experience. Your comparison is much more effective because you are now working on an apples-to-apples basis.
Comparisons are useless if the items being compared are grossly dissimilar. Of course, not every comparison can be made on perfectly equal terms, but that doesn’t mean an investor is completely powerless. The more equal they can make their comparisons, the better.
Why Make Comparisons to Begin With?
Now that we’ve gone over the importance of making fair comparisons, we can now tackle the big question: why make comparisons in the first place?
As we briefly talked about at the start of the article, there are very few, if any, absolutes in investing. That is, just because you find yourself above or below a certain value doesn’t immediately mean you are doing better or worse than others.
There aren’t any “magic numbers” that investors need to reach in order to call themselves “successful”. Conversely, just because investors fail to achieve some arbitrary number doesn’t automatically mean they’re failures.
Instead, relativity is the name of the game. Almost everything you do in investing is only as good or bad as what it’s being compared to. To illustrate this point, let’s look at some examples.
A company that generated $5,000,000 in net income in the past fiscal year looks great until you realize that, compared to its competitors and the wider industry, they are well below the industry average of $50,000,000 in net income earned over the same period.
When using any sort of investment ratio or metric, you won’t know if the values you calculate are good or not unless you have some frame of reference. A company with a trailing P/E ratio of 15 may look good, but when you realize that the company’s average historical P/E ratio has always been less than 10, then that figure isn’t so attractive anymore.
Achieving a 12-month trailing return of 15% may not sound so impressive, but if your previous 12-month trailing returns for the past several years never exceeded 8%, then this is a clear sign of improvement, and a potentially brighter future waiting down the road.
No matter how many examples we go over, our point still stands: how you’re currently doing is only as good as what’s going on around you.
Good comparisons are so powerful because they serve as a clear reality check. It’s easy to tell yourself that your strategies are working as intended and that your judgments are correct, but the reality could be very different, for better or for worse. You won’t know what that reality is unless you go out and make those comparisons.
Additionally, comparisons elucidate insights that previously would’ve gone unnoticed. Measuring portfolio performance every year is great, but only when you compare it to performance figures from previous years will you know if your portfolio is heading in the right direction or not. You wouldn’t be aware of the direction your portfolio is headed if you simply looked at yearly performance in isolation.
In a way, making comparisons is also a form of proactive risk management. That’s because good comparisons can bring certain problems to an investor’s attention, and those problems can be rectified long before they devolve into major ones.
What Happens if You Refuse to Make Any Comparisons?
Now, it’s very easy to say “Make comparisons to gauge how you’re currently doing”, and for many investors that usually isn’t a problem. For some, however, this may prove to be a challenge.
Some investors may refuse to make any sort of comparison because they aren’t ready to face the truth. Any investor can comfort themselves by believing that they’re doing great, but they will only find out if that’s true or not by comparing themselves to some clear benchmark.
While you may gain some peace of mind by choosing not to make any comparisons, this will only provide temporary solace. Eventually, the realities you choose to ignore will become too big and too problematic to turn a blind eye towards.
Whether it’s hubris, ego, or fear, there are many potential obstacles that can prevent an investor from drawing any comparisons.
If, for whatever reason, an investor finds it too difficult to make comparisons, it’s important to remind themselves why they’re being made in the first place: to get a clear understanding of how they’re doing based on what’s going on around them.
Comparisons aren’t made as a way to discourage investors or to stroke their egos, and if they are, then they aren’t of much use.
Sometimes, the reality that investors discover may not be so bad, while other times it may be very difficult accept. However, if an investor is serious about achieving their goals, they must learn to move past their mental obstacles and accept the reality they’re dealing with.
Wrapping Up
There are very few, if any, measures of absolute success or failure in investing. Instead, you’re only as good as who or what you’re being compared to.
Making good comparisons is so important because it gives investors a reality check of whether they’re performing as well as they think they are. Any investor can say their portfolio is doing great or that the prospects they’re looking at are better than the rest, but they won’t know if that’s truly the case until they compare those claims against a clear benchmark.
Because of the harsh realities that comparisons sometimes bring to light, it’s easy for investors to forego making them in an attempt to comfort themselves. After all, ignorance is bliss, right? While this may provide some temporary solace, burying your head in the sand won’t make certain problems go away – only when an investor confronts reality will they have a fighting chance to achieve their goals.
