In his new book, “The Tyranny of Metrics,” history professor Jerry Z. Muller argues that investors’ obsession with using quantified metrics for performance assessment can lead to a focus on the wrong things. To satisfy this “quantification addiction,” people focus on those things that can be quantified but are unimportant, while marginalizing those that are not quantitatively measurable but are truly important.
Put simply, we force square pegs into round holes, and try to quantify the unquantifiable. This induces gaming behavior that eludes the purpose of the quantification, and can make actual investment performance worse.
In no field is the tyranny of metrics more prevalent and more misguided than in finance. Both individual and institutional investors — and their advisers, consultants, and investment managers — are obsessed with performance metrics.
The current methodology for finance research, assessment, and prediction, however, is utterly insane. What is important to an investor is the investor’s future investment performance. But quantified data studies must look backward on data from history, not the future, because there is no such thing as future data.
The overwhelming weight of evidence, however, shows that in the investment world, historical data cannot predict the future.
Investors should focus their investment decisions not on statistical combinations of past returns, which can be quantified only in retrospect, but on how their investments will create future value, even if it can’t be quantified. Trying to measure the value created in advance, in precise quantitative terms, would be a fool’s errand.
Read: Why Apple stock is still a buy — even at $200 a share
Also: Most fund managers can’t get over this one big hurdle all investors face
Into this frenzy of metrics-obsessive goals distortion comes a new proposal for corporate reporting, known as Integrated Reporting. It has been taken up by prominent corporations and embraced by the CFA Institute, the organization that offers the respected Certified Financial Analyst designation.
Integrated Reporting focuses on “how an organization creates value over time.” It categorizes six types of “stocks of value,” or capital: financial capital; manufactured capital; intellectual capital; human capital; social and relationship capital, and natural capital (all renewable and non-renewable environmental resources).
Thus, it subsumes not only conventional financial reporting but the new trend toward “sustainable” investment reporting that focuses on environmental, social, and governance considerations (ESG).
No specific metrics or means of quantification are required. The Integrated Reporting framework document explicitly states that “It is not the purpose of an integrated report to quantify or monetize the value of the organization at a point in time, the value it creates over a period, or its uses of or effects on all the capitals.” Nevertheless, the document acknowledges that quantification can be useful when “[r]elevant to the circumstances of the organization” and “reported on through a combination of quantitative and qualitative information.”
Muller acknowledges in his book that the use of metrics can be helpful when used internally by an organization as an aid to assessing itself. Metrics become counterproductive when applied externally, as rigid standards to make comparisons across disparate organizations or individuals.
Such rigid standards are now, unfortunately, imposed on asset management and its evaluation mostly by the industry that consults to institutional investors on asset-manager hiring and performance measurement, and by advisers to individual investors. These rigid standards involve quantitative evaluation relative to benchmarks, all of it backward-looking.
In order to become relevant to investors’ emerging demands, the asset management business will have to pry itself loose from rigid adherence to metrics. This will be difficult because the “tyranny of metrics” is deeply embedded. Yet it must be acknowledged that finance and investing is the area in which metrics are least applicable, but where numbers are most readily available — indeed too readily available.
Michael Edesess is co-author of The 3 Simple Rules of Investing: Why Everything You’ve Heard about Investing Is Wrong — and What to Do Instead Berrett-Koehler Publishers (2014).
Read: Winning investors know that stocks are money machines, not slot machines
