To invest or not to invest, that is the question.

"We have given a return of 35% compounded over the past 5 years. You should invest with us."
"The stock markets have not lost money over any 10 year period. So you should invest in the stock markets with a long term horizon."
"At this stage, there is very little risk in the markets. So let us help you invest now."

Such claims and more are frequently made to gullible investors by mutual funds sales people and individual investment managers/advisors alike. Most get sucked in by such talk and invest. Some realise later that they made a mistake.

How should you evaluate whether an investment or a money manager is worthy of your hard earned money? Should you invest with someone who has returned 30% over someone else who has returned 20%?

There are many standard tools (Risk-adjusted returns, standard deviation, Sharpe ratio, Treynor ratio, Sortino ratio, etc) to measure investment performance. I am not sure they represent the correct way to measure investment performance. Hence allow me to present how you should do this.

At the core, whether you should invest boils down to this: Will the investment help you achieve your return objectives in your time horizon without causing financial ruin or discomfort? If yes, then invest. If no, let it go.

But first, let us understand and, more importantly, embrace the concept that in investments (as is the case with all things involving chance) luck is an important element in determining success. While all of us might like to believe that investment success is an outcome of skill, that is only partially true.

It is quite possible that an overall beneficial environment can make an poor money manager look brilliant while a brilliant manager might look mediocre. So how do you know whether a money manager has succeeded because of luck or skill? While theoritically you may never come to know about this, you can come to a conclusion based on the long term performance of the money manager.

How long is long? There is no right answer but 10 years is a long enough time for you to get an idea. The basic idea behind choosing 10 years is that in 10 years, hopefully, the money manager would have seen bull and bear markets. So you would know how the manager has fared through different market cycles.

Should the manager be process driven? There are some managers who have special skill in managing money. Others follow a sound process. There is no right answer for this and in my opinion, following a process is not a criterion you should use to evaluate performance.

Rather what is more important is whether the fund manager follows one/more investing philosophies. An investing philosophy guides decision making. Of course, the fund manager should have an investing philosophy that is based on reason. And he should be able to explain this philosophy to you in 2 minutes. ' Technical analysis' or concepts that have a wide scope cannot be an investing philosophy. Within technical anlysis one investing philosophy could be trend trading. That's a valid answer rather than merely stating broad concepts.

Having established that the fund manager has a long track record using a valid investing philosophy, you come to performance parameters.

Return:
This is quite obvious. We all seek higher returns. What returns has the money manager obtained over the long term?

Should returns be stable? That depends upon the investor. Some people like stable returns, some do not mind swings in performance. As long as the compounded returns in your desired time horizon are upto your satisfaction, that is fine.

(Note however that if your time horizon is not long, and returns by the money manager are not stable, you might not be able to achieve your returns over this shorter time period. Hence you are better off with an investment/money management that gives stable returns.)

Risk:
But looking at returns without consideration for the risks is incomplete. People talk about risk adjusted returns. Many do not understand what risk really is. Academicians talk about Beta as a measure of risk. But Beta is merely a measure of volatility, not of risk. Similarly standard deviation is a measure of volatility of returns, not a measure of risk.

Risk to you refers to the chance of not meeting your desired returns in your desired time horizon. Let me repeat this: risk to YOU refers to the chance of not meeting YOUR desired returns in YOUR desired time horizon.

So let us say that your investment horizon is 3 years. You are evaluating the performance of a money manager over the last 10 years. In 10 years you will have eight 3-year performances (assuming year start or year end dates only). If you see that across all such periods, your investment returns of 15% have been met, then the manager did a wonderful job of managing risk FOR YOU. What happened between any 3 year period is simply volatility and not risk. You could have taken money out at the end of any 3 year period and felt satisfied having met your desired returns.

If however you see that in 4 of the 8 3-year periods, your expected return has not been met by a maximum of 4%, risk to YOU is 4%. Whether a 4% risk is acceptable to you is a personal decision.

But, if your time horizon is 1 year and the maximum deviation in any one year between achieved return and desired return is -30%, the investment bears very high risk regardless of the fact that over any 3 year period, the manager might not have lost money!

Risk is time dependant!

Volatility does bother us and we dont like to see our net worth go down, at least not go down much.

So we come to...

Draw downs:
Draw down is the crest to trough move in our capital. It is the difference between the max level in our money and the min level in our money before a new high in capital is achieved. So if the value of our investments goes up from 100 to 150 and corrects to 130 before it moves higher, the draw down is 150-130 = 20.

Draw downs can make us uncomfortable and anxious. No one really likes to see their wealth go down, even if it is only on paper. The smaller the draw downs, all other things being equal, the better is the investment performance. Some people are comfortable with large draw downs, others want it to be small. Look at the investment performance if the manager and see what has been the (1) largest draw down and (2) average draw down. If both are within your comfort zone, the investment is ok for you. If not, you should invest less such that the drawdown on your total capital is acceptable to you.

Knowing what is an acceptable draw down and what is not is somewhat tricky. You might think that a certain draw down is acceptable to you. But when that draw down comes, you might realise that it was set too high or too low. It requires some experience with draw downs (and with investing) to arrive at a comfortable number to draw down.

So we say that, any investment or money managent that helps YOU achieve YOUR return objectives in YOUR given time horizon without causing financial ruin or discomfort, is investment worthy.

Notice how I have not even mentioned yearly returns, or standard deviation of returns or fancy terms like Sharpe Ratio, Sortino Ratio, or Information ratio. I have not alluded to alpha or beta or other Greek alphabets that experts love to talk about.

Investing is a financial journey. You want to get to your destination within a given time without losing your life and without the journey being uncomfortable. You should take any vehicle that meets your requirements.