January 11, 2012
For decades, the annualized returns of asset classes, individual securities, and managers have been front and center in every consideration of investment results and investment choices. While readily available and easy to calculate, annualized returns have little bearing on whether investors are actually en route to meeting their goals.
This is because annualized performance ignores cash flows—which can have a huge impact on outcomes, depending on the sequence of returns. Further, focusing on annualized returns tends to encourage performance chasing, which is apt to lead to buying high and selling low: the opposite of every investor’s goal.
Rather, what we believe investors need is the equivalent of the GPS on so many car dashboards—a measure that tells drivers where they are and how to reach their destination. We call that measure core capital: the amount of money investors need to have a high probability of meeting their spending requirements, even in markets far worse than they’re ever likely to see.
The core-capital line for every investor depends primarily on his or her spending requirements, asset allocation, and age: The older the investor, the less he or she will need to support a budget lifelong. And investors who regularly monitor their positions vis-à-vis their core-capital line are probably more likely to rebalance when their allocations get out of synch and even realign their portfolios at the best times for increasing or decreasing risk. These midcourse corrections can help build and preserve capital.
In short, focusing on core capital, a customized approach to measuring performance, is likely to promote the most important investment gift of all: peace of mind.