You Measure Investment Success in Absolute Terms, Does Your Financial Advisor?
Investing has never been easier to do and more difficult to understand than it is today. Back in the early 1980’s when I first started investing, the mantra was: buy stocks for the long run. Then, after the crash of 1987, the message evolved into: build a balanced portfolio with 60% in stocks and 40% in bonds to protect your portfolio from any bumps in the road while growing your capital.
Nearly 30 years later, we have seen an explosion of investment products available to us. The two basic securities known as stocks and bonds have been sliced and diced by market cap (large, medium, small, and micro), growth versus value, yield, industry sector, country, quality (high or low), taxability (taxable, tax free, tax deferred), maturity (from long to short), coupon (again high or low), etc. Additionally, investors today also have access to options, futures, FOREX, precious metals, and real estate either directly or through mutual funds, Exchange Traded Funds (ETFs), or Exchange Traded Notes (ETNs).
Investors also have a seemingly never ending variety of advice on how they should be investing their personal assets. Some of these sources directly contradict each other!
Investment luminary and Vanguard’s founder John Bogle admonishes investors that matching market-based returns, especially when using his low-cost Vanguard branded funds and ETFs, yielded better results for most investors than picking individual stocks, market-timing, or any other investment strategy.
At the same time, Bloomberg columnist and wealth manager Barry Ritholtz reminds us that numerous studies have pointed out that weighting indexes on just about any fundamental basis other than market capitalization not only outperforms market-cap-weighted indexes (think S&P 500 and the like), they do so with less volatility.
Relative Performance: Success Is Beating the Market, Whether You Make or Lose Money
In all cases though, the assumed basis for measuring the merit of such sage advice is the performance of your individual account relative to some kind of benchmark, usually a broad-based market index like the S&P 500 for stocks and the Barclays U.S Aggregate Bond Index for fixed income.
The theory is that as long as you beat the index, you are doing fine. But is that really the best way to measure how you are doing when it comes to building and protecting your personal wealth?
In 2008 the S&P 500 lost 37%, so if you had started the year with $100,000 invested in a passive S&P 500 index fund, your account balance would have been reduced to $63,000 by the end of the year. Assuming you didn’t panic and just held on to the same fund, you would have waited until 2013 before your account was back over $100,000 in value. So, the question is: would you have felt much better if you were invested in a market beating fund (a relative out performer) that “only” lost $30,000 (for example) of your money in 2008?
While performance relative to a benchmark has become the generally accepted standard in the investment industry, most individual clients, whether they realize it or not, still focus on absolute returns. In other words, they really don’t care as much about beating a benchmark as they do about growing and preserving the money in their individual accounts. Many managers lost clients after 2008 even though they beat the market. Reason? They still lost an unacceptable amount of the client’s money!
The Absolute Return Alternative: Success Is Measured in Dollars Made
An alternative to the pervasive relative performance measure is absolute return. Absolute return is simply the appreciation or depreciation of the asset (stock, bond, fund, or portfolio, etc.) over a given time period. For example, if you invest $1,000 in a single stock and one year later that investment is worth $1,100, your absolute return is $100 or 10%.
Unlike traditional investment strategies, a strategy that pursues an absolute return is not measured against traditional market indexes but rather against its own return goals.
For example, an absolute return strategy may seek to outperform Treasury Bills by a certain margin since T-Bills are considered to represent the risk-free rate of return by many investment professionals. As such, absolute returns focus the investment manager on the most basic concern of the client – achieving a positive real return that enhances the client’s purchasing power.
Absolute return strategies are different from tactical strategies which dynamically increase or decrease exposure to asset classes in anticipation of or in response to changing market conditions. Instead, a manager deploying an absolute return strategy will use various asset classes and/or various hedging techniques, which may include derivatives and shorting, to attempt to achieve stable returns with moderate volatility.
The stability of returns is critical; they are trying to achieve an investment objective of positive annual returns with a consistent level of volatility, year after year regardless of what the market is doing. Remember that an unending string of positive returns is the goal, not a guarantee, and that the risk of incurring some level of loss or missing the goal is never truly eliminated regardless of what investment tools the manager may be using.
There are many absolute return strategies and each one offers its own unique approach to meeting a desired goal. Interested investors should try to understand the underlying strategy, its inherent risks, and its track record (in absolute terms of course!) before committing capital to any investment product.