Wednesday, September 8, 2010

Consistency doesn't necessarily make things right

When I was in the Field Artillery (many years ago), a gun battery would, once it had established a new position, orient their weapons to adjust for any misalignment which may have taken place since the last time they had been calibrated. This way, if a howitzer was consistently off, by adjusting for it the result would be as desired. A similar thing occurs with some golfers. For example, those who consistently slice the ball may aim to the left (for right handed golfers) of the fairway, knowing that their slice will cause the ball to go to the right, and hopefully in the fairway. Translation: in some cases, consistent errors can be dealt with to achieve the desired result; but this isn't always the case.

We generally want to see firms employ consistency when it comes to performance measurement. GIPS(R) (Global Investment Performance Standards) is one source for this desire. For example, firms need to be consistent in how they employ their rules for discretion, for their timing of adding and removing accounts, and for composite compositions. But if what you're doing is wrong, doing it consistently doesn't make it right.

Case in point. We have a client who employed a non-standard method to calculate performance; by "non-standard" I mean that it was invalid. The results would be often erroneous. Although they recognized the flaw in their method, they felt that by employing it consistently, somehow the error would be eliminated. Unfortunately this line of reasoning is invalid: consistently employing an invalid formula will only yield an invalid result.on a consistent basis (which might, in fact, mushroom!).

I do find it a bit odd that with all the documentation on how to derive returns, that individuals and firms will still come up with their own return method. And if they do derive their own approach, they should at least have it validated by an independent third party. Twenty-five years ago there wasn't a great deal that was readily available on how to calculate performance; today there are dozens of books and probably hundreds of articles, and loads of websites that can be referenced.

This wasn't the first time we've encountered firms who use their own formula. Often the methods that firms come up with seem quite intuitive; unfortunately, they're invariably wrong, however. What may seem to make intuitive sense often fails mathematically.


  1. I would be curious to hear what the formula was!

    The other day I had a client calculate performance by simply graphing the market value of the account with cash flows subtracted at the moment they occurred.

    I didn't know where to begin telling them how wrong that was!

  2. Thanks for your note.

    Without going into detail I will simply say that they were ignoring cash flows.

    Yes, some of the methods are quite intriguing.


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