Are you investing for absolute returns or relative returns? And, do you need to change your thinking on this?

 To begin with, you need to understand what the two terms mean: (From my book, The One Thing)   

Relative Returns are what your returns are in relation to whatever index you are measuring them against.  For instance, a large cap growth fund measured against the S&P 500 Index. 

Absolute Returns are concerned with the return of a particular asset and how it fits in with the overall portfolio investment goal.  So, if someone comes to me with a desire to achieve a 6% annual return, then my goal is to design a portfolio of assets that will seek to hit that target year in and year out, regardless of what any of the Indexes are doing. 

Market indexes (like the Dow or S&P 500, that most people see on the news or internet every day) don’t have expenses associated with them, so even index funds that try to match them are not going to do so because of the internal expenses associated with the index fund.  But do you really want the returns of an index fund anyway?

I remember back in 2003, sitting down with a potential new client.  We had discussed a number of financial planning issues, but when it got around to talking about investments his countenance took on a whole different look.  I watched as his brow furrowed and arms crossed.  “I invest in index funds,” he smugly announced. 

I nodded my head and replied, “So how did you like your returns last year?”  I knew full well that the S&P 500 Index was down -22.1% in 2002. 

 “I didn’t like it,” he responded. 

“Well, instead of staying 100% invested in stocks, many active managers moved some money to cash, bonds, and other investments and avoided losing so much,” I replied. 

Many times in new meetings I will ask the question a different way.  “In 2008, the S&P 500 Index Fund was down  -37%.  I’m sure you wouldn’t be happy with that, but would you be happy only being down  -20%?  Because there were mutual fund managers that were paid big bonuses for beating the index and only losing about half as much.” 

You would think that if someone wants to beat the index, they would be happy with only losing -20% instead of -37%, but I’ve never had someone respond that they were.  What this really says to me is that most investors are more interested in absolute returns versus relative returns.

Comparison in financial markets can lead to remarkably bad decisions. Such as investors having trouble being patient and letting whatever process they have put in place work for them.

For example, if you made 10% on your investments, but only needed 6%, you should be pleased. However, when you find out everyone else made 14%, you feel disappointed. But why? Does it really make any difference?

A prudent financial planning approach to investing is to review your long-term goals and determine what return is needed to accomplish them.  Then you can make the best decision in regards to your investments.  If you only need a 6% return, then you don’t have to take higher risk to try and achieve 12% annual returns. 

If you want to be happy, in regards to investing, the first thing you need to do is eliminate that which is making you unhappy, which is all of the comparisons.