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Relative vs absolute performance: The dangers of going down the relative performance wormhole (part I)

 
15 | Mark | 2010/11/07 | Print |
 
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Relative vs absolute performance: The dangers of going down the relative performance wormhole (part I)

In the investing world, one of the things most obsessed about is striving to beat the market. Trying to do better than average; trying to generate ‘alpha’. But to be a successful investor, don’t be distracted by the smoke and mirrors of ‘outperformance’.

The allure of alpha is deeply psychological: Performing ‘in-line with the market’ is, by definition, average. The middle. And nobody wants to average in anything, especially when it concerns your hard-earned cash. The desire to get the best possible returns on your money is natural. But this is a fallacy.

Don't focus on relative performance


The crux of the matter is that while beating the market really appeals to our inexorable search to ‘be better’ (in just about everything we engage in, not least investments), it’s just not relevant in helping you achieve your goals. Sensible investing is about designing a portfolio that’s best suited to your needs and objectives. When you’re investing your money you should do so with an idea of what you want to get out, not by how much you want to outperform others.

Here’s an example: Say you are looking to buy a house as an investment, and have narrowed your search down to two places, and in very different neighbourhoods. The one neighbourhood just seems horribly overpriced because it’s very in vogue, but you do manage to find a house that’s good value for money relative to the other houses on the street... and you’re certain that, come what may to house prices in the neighbourhood generally, your property should at least be the best investment in the area. The other place you’re considering is in an up-and-coming area that’s yet to get the attention it deserves but seems bound to take off in a few years – but, the house you like is a little more expensive than the others in the vicinity. Which do you choose as an investment?

You choose the one that’s going to ultimately put the most money in your bank account. And how the value of your neighbours’ house fared is irrelevant. Of course, it’s natural to want to feel like you got the best bargain in your neighbourhood, but that’s really just a psychological hang-up and a distraction. Said differently, would you rather have your house’s worth grow at a healthy 8% per year but do worse than other houses in your neighbourhood, or would you rather have the value of your house better than other houses in the neighbourhood but only grow at 5% a year?

Why the fuss about relative performance at all then?

Relative performance has so much prominence because it is a simple way for similar funds to compare themselves against each other. For example, if two funds both invest in US Equity, they might both use the S&P500 index as the benchmark, and then their performance vs. this benchmark is a way they can measure which was more successful. This can be a useful metric in helping you decide which of these similar such funds you want to invest in.

However, this only matters IF you have decided to invest in US Equity at all. That is the much bigger question, and one that is properly centred on your investing objectives. Since your goals are absolute in nature (and not quantified in some 'relative to benchmark' notion), you should keep focused on asset allocation. Then, once you've committed to a certain asset allocation, you might want to consider relative performance as a way to choose funds within each of the underlying asset classes.

However, investors often forget the context in which relative performance matters and should be considered, and overestimate the importance of beating the market. It might be important for the fund manager1, but it’s not important for you, the diversified, multi-asset class investor.

Is relative out-performance even possible?

In the foregoing, attention to relative performance was put in its rightful place: subordinate to asset allocation. But, maybe this was overly generous. Is relative performance worthy of any attention whatsoever, or is it just an ephemeral mirage? Is relative out-performance something that is consistently attainable?

We'll follow up with this in part II...

_________________________________________________________________________

1: Fund managers try to beat their benchmark partly in order to attract money from investors. They are also rewarded for relative performance and incentivised to outperform their peers. Investment organisations offering products that vie for your money need some form of tracking how good their product or performance is, both to prove their worth to you and as a mechanism to measure their actual performance. And it is the promise of outperformance that allows managers to justify their existence and the fees they charge you.

 

 
15 | Mark | 2010/11/07 | Print |
 
  Back to all posts
 
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Mark
2529 days ago

Thanks to Super Saver for including this in the Wealth Builder carnival #15!



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