A Complete Guide to the Futures Market, 2nd Edition

CHAPTER 20

How to Evaluate Past Performance^*

■ Why Return Alone Is Meaningless

You are looking for a London hotel room on the Internet. You find the same hotel room at two different sites (both including taxes) at two different prices:

• Site A: 300
• Site B: 250

Which is the better deal? The answer may seem obvious, but it’s not. On one occasion, when I posed this question to a conference audience, one attendee shouted the response, “It depends whether they both include breakfast.” “That would have to be a very expensive breakfast,” I answered. But at least he had the right idea. The question I posed contained incomplete information. I didn’t specify what currency the prices were quoted in. What if the 300 price was in dollars and the 250 price was in pounds (let’s say when the pound was at $1.40)? Changes everything, doesn’t it?

“Well,” you are probably thinking, “no rational person will ignore the currency denomination in comparing two prices, so what’s the point?” The point is that investors make this type of error all the time when selecting investments by focusing only on returns. Comparing returns without risk is as meaningless as comparing international hotel prices without the currency denomination. Risk is the denomination of return.

Consider the two managers in Table 20.1. Assuming the two managers are considered qualitatively equivalent, which is the better-performing manager?¹ Many investors would opt for Manager B, reasoning, “I am willing to accept the higher ...