Tuesday, January 25, 2005

Peer Pressure

Ron Surz warns investors about the dark side of using peer universe comparisons. According to Ron:
  • "..traditional peer groups are hazardous to our wealth because they are more likely to mislead than to inform, so we make the wrong decisions," he says. "Making hire/fire decisions on the basis of peer-group rankings is fraught with peril."

The world of prudent investment decision making contains very few black and white rules. At best, we can be guided by general principles that over the long run make conceptual sense and have correlated with successful investing. There are no benchmarks, indicators, comparators, algorithms or metrics which, in and of themselves, will always provide the the right decisions. Any of them, if used without discretion, can support the wrong decision. That is why prudent investors generally use many attribution and measurement tools, inclusing peer universe data, over a period of time. Looking at investment performance using a broad range of comparisons such as benchmarks and peer universes, across many characteristics such as style, returns and risk should provide the best comprehensive performance picture for investment decisions. The key is understanding the value and limitations of each tool. While Ron makes some good points, I think he grossly understates the utility of carefully selected peer universe.

Good fiduciaries and investors are by nature and training cynical. When propositions are delivered as absolute truths and in uncompromising terms, you should begin asking lots of questions and searching for ulterior motivations. I think Ron has developed an interesting monte carlo universe (in case you wondered about the motivation) that would have value as an additional analytical tool. However, I would feel more comfortable firing a manager because they underperformed an "imperfect" peer group rather than 100,000 monkeys randomly picking stocks.


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