Absolute or Relative Returns
Relative Return Approach
Why do you invest? Is it to match or “beat the market?” If your goal is to match or beat the market and the market is down 12% for the year while you are only down 10% you did a good job, right? Are you happy that you only lost 10%? Is it because you believe that the market “averages” 10% a year and in the “long term” it will all balance out? This follows a relative return approach. Your goals are set relative to a benchmark. Your risk is related to the variance from a benchmark, a.k.a. tracking error. Are you a rational investor? If so, let’s reason this through by first looking at some of the above assumptions. One assumption common among investors is the market “averages about 10% a year.” This is quoted frequently by Wall Street when they are selling mutual funds, but if you read the fine print you will notice that this “average” is based on about 80 years of data . So, if you are going to rely on this assumption then your time horizon must be similar, correct? So if you are happy that you only lost 10% while the market lost 12% because you believe that in the long term defined as about 80 years it will balance out then your reasoning is fine. However, if your time horizon is 10-20 years then it is not rational to assume that the market averages 10% per year. If you look at the history of the market you will see that over the past 100 years there have been numerous 10-20 year periods of time when the markets have been flat or down.
For some reason, it seems Wall Street does not want you to entertain the possibility that over the next 10-20 years we may end up with the market averages flat to down. Maybe this is because they are selling mutual funds that are benchmarked to the major indexes. If they can get you to buy in to that investment strategy predicated on matching or beating a benchmark by two or three percent instead of a profit and loss statement, then if your portfolio and corresponding benchmark have gone nowhere in 10-20 years, you can’t be upset. It’s all in the fine print.
Another point made by Dr. Sam Savage Consulting Professor at Stanford and founder of Analycorp is what he calls the “Flaw of Averages.” He states that many people when faced with uncertainty, like future market returns, interest rates, or future sales, succumb to the temptation of replacing the uncertain number in question with a single average value. The flaw is the fact that the average doesn’t take into consideration the volatility between returns.
He believes this is a fallacy as fundamental as the belief the earth is flat. The main point he makes is that “plans based on average assumptions will be wrong on average.” To put it more bluntly, in an article in the San Jose Mercury News he states “If you count on the stock market’s average return to support your retirement, you could wind up penniless.” For those of you who are mathematically inclined you may realize that the “Flaw of Averages” is Jensen’s inequality.
Absolute Return Approach
If you invest as if you were running a business in which your objective is investment gains regardless of a benchmark then you are following an absolute return approach. Your risk is your probability of loss. So if the market goes down 12% and you are down 10%, you are not happy. You don’t rationalize your losses by comparing them to a benchmark. A loss is a loss.