There is a societal construct that perpetuates comparison among human beings. We are always trying to “keep up with the Joneses.” We naturally compete in nearly all phases of life. General George S. Patton once famously said, “Americans love a winner.” It is this drive to compete that often has us comparing with one another and that invariably bleeds over into our finances. We often misconstrue “absolute returns” for “relative returns.” This mistake can many times lead us into making further mistakes with our investments. In this brief report, we contrast absolute and relative returns, along with how investors can avoid critical investing mishaps when confusing the two types of return.
Absolute vs. Relative Returns
Investors will often say they want “relative returns” when, in reality, they really want “absolute returns.” So, what is the different between the two?
Relative Returns are the return sets on your portfolio(s) that compare to a particular benchmark index.
Absolute Returns are the return sets on your portfolio(s) alone on a year-over-year basis.
The former type of return feeds into our inherent desire to keep up with or beat a particular benchmark or other portfolio—perhaps the investment portfolio of a close friend or relative. The latter type of return is simply the return our portfolio achieves and whether or not that return aids in our ability to achieve a desired goal. Wall Street, and sadly, investment advisors, convince clients that they should strive for the former. However, this type of behavior leads to never ending unhappiness in pursuit of something can never be achieved. If I am always comparing my portfolio’s performance to something else, one of two results will continually confront me—first, at some point, my portfolio will under-perform the index or friend’s portfolio that I use for comparison, or second, I will constantly search for a benchmark my portfolio can beat, which leads to madness. William Penn once said, “The jealous are troublesome to others, but a torment to themselves.”
Here’s an example of how relative returns can be maddening. Let’s suppose that your friend gave you a check for $50,000 at the end of the year as a Christmas present. After ten years, your friend has given you a total of $500,000! Great friend, huh? Now, after ten years of generosity, let’s suppose that you learn your friend has been giving other friends that you share in common $100,000 per year at the end of the year for the past ten years. You probably felt very blessed to have a friend who had given you $500,000, but once you discovered your friend had been twice as generous with your other friends you probably experienced anger, right? This is the fallacy of relative returns.
Investors who work with a financial planner know that their planner tries to determine what the client needs to generate in terms of return on assets in order to hit a stated goal—retirement, purchase of a home, etc. Which is more important—a return plus/minus the S&P 500 Index, or the amount of returns needed to get you to your goal? In the example to the right, an investor deposited $400 per month in an investment account from age 25 to age 60 and had a total portfolio worth more than $787,000 at the end of that period.
Assuming a financial planner had determined that the ending amount was exactly what the client in this case needed in order to meet their financial goal of retirement, what would the rate of return matter at that point? Would it surprise you to know that the rate of return in this assumption was only 6% annually? That rate of return is almost half the annual rate of return for the S&P 500 Index over the last 40 years.* In this case, the return of the S&P over the same time period was irrelevant. The client achieved his/her goal via “absolute” returns regardless of the “relative” returns of the index. The lines get blurred when you make 12% on your investments in a given year, but, as in the example above, only needed 6%, you should be pleased. However, when you learn everyone else made 14%, you feel disappointed and this leads to the madness of relative returns.
An individual investment, say a large cap core mutual fund should be compared to a relevant index. However, the overall portfolio of investments should be measured by a financial plan. Quite frankly, comparison-related investing is for Wall Street’s benefit. When people get upset, they tend to move money around in a frenzy and that tends to create fees and commissions. The inception of more benchmarks and product styles aids in creating an environment where investors are in a perpetual state of disappointment. So what are investors to do?
Changing one’s perspective from “relative” returns to “absolute” returns can increase long-term results and can aid in overall happiness. If you can bring your behavioral biases under control, you will tend to invest less guided by emotions and more guided by achieving your goals. When investors make decisions based on emotions, rather than on a specific strategy, excessive risk is usually the result. If you want happiness (in general), you need to remove that which makes you unhappy. In this case, it’s constantly comparing your investment results to an arbitrary index. Here are some helpful differences between an index and your portfolio to remember when making comparisons#:
- An index contains no cash, unlike your portfolio which may have liquidity needs.
- An index does not have a life expectancy, unlike the goal that your assets need to support.
- An index does not have to compensate for distributions to meet spending needs in retirement.
- To meet or exceed the returns of an index, an investor must take on equivalent or greater risk as the index.
- Indices have no taxes, costs, or other expenses associated with it.
- An index has the ability to substitute a holding without a penalty or costs, unlike your portfolio.
A good example of why chasing “relative” returns can end badly is the 2000 Tech Bubble (see graph). If you were investing $500,000 in 1994 in a balanced portfolio—50% equity and 50% fixed income—because your financial advisor showed you an analysis of how that mix would get you to your stated goal—$1,000,000 in 8 years for retirement, you might have been disappointed on a relative return basis. In 1995 and 1996, an all equity investment in the S&P 500 Index would have generated a return of 69% in just 2 short years. Your Balanced portfolio, would have returned a very healthy 45% return, but it wasn’t as much as the S&P 500. An investor chasing relative returns would have turned greedy and shifted all of their investments from a 50:50 mix to 100% equities. That would have proved detrimental to the goal of retiring in 8 years. While the 100% equity investment in the S&P 500 would have generated much better success by 1999 (5th year), it would have also caused the portfolio to experience more than 5 times the losses during the Tech Bubble (2000-2002). This would have subsequently caused the greedy investor to have less than the $1 million in investments by the 8th year (retirement), while the Balanced portfolio, had the investor stuck with it, provided an ending result above $1 million allowing for retirement.
The lesson to be learned is that most of us want all of the returns without all of the risk—a feat that is impossible. The problem with chasing “relative” returns and/or being greedy is that back-to-back detrimental losing years in your portfolio can compound losses. Instead, we should learn to love what is needed to get to our goal. By not losing an inordinate amount of principal in down years, it is possible to beat average market returns by utilizing the power of compounding. To be a better investor, learn to do what most investors don’t:
- Look for stable returns—not the highest.
- Invest for a reasonable return that will help you reach your goal.
- Don’t compare your portfolio to some arbitrary index.
Investing is relatively easy—formulate a sound investment plan and stick to it.
Notes & Disclosures
*Slickcharts.com (S&P 500 Total Returns by Year Since 1926 (slickcharts.com))
#RIA Advice (Absolute vs. relative returns (realinvestmentadvice.com))
This report was prepared by Eudaimonia Asset Management, LLC and reflects the current opinion of the authors. It is based upon sources and data believed to accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
Graph #2: Calculations represent $400 monthly investments growing by a constant 6% annually for 40 consecutive years. All calculations done by Eudaimonia Asset Management, LLC. It is not possible to invest directly in an index and constant returns may not be possible with most investments.
Graph #3: Calculations represent the growth of $500,000 in 100% equity (S&P 500 Index) and the growth of $500,000 in 50% equity (S&P 500 Index) plus 50% in fixed income (Bloomberg Barclays US Aggregate Bond Index). The “Greedy Portfolio” represents an investment in the 50:50 portfolio for the 1st two years (1995 & 1996), then switching to 100% equity portfolio. Returns for the S&P 500 Index are derived from: (S&P 500 Total Returns by Year Since 1926 (slickcharts.com)). Returns for the Bloomberg Barclays US Aggregate Bond Index are derived from: (Bloomberg Barclays US Aggregate Bond Index - Bogleheads).