Absolute returns get a lot of lip service, but we have a relative return bias. Peter Bernstein weighed in on the bias and suggest benchmarks don’t help.
The downsides are fairly obvious. Relative returns feel great during bull markets. But when a year like 2008 comes around, you beat the benchmark but still lose big.
To add to it, fund managers (and advisors) also have career risk that feeds the relative return bias. All of it leads to more opportunities for short term thinking and poor behavior.
Seth Klarman simplified the problem perfectly: “You can’t think straight with a gun to your head. If you have a relative performance gun to your head, on the way down and on the way up, you’ll do the wrong thing every time. You’ll be liking them when they’re up, and hating them when they’re down – when you should be doing the opposite.”
Absolute returns should be the answer but investors contend with a powerful force: return envy. You have to be comfortable with “losing” to the Jones or an arbitrary index in any given year. What matters is “Are you earning a good return?”
Here’s what Bernstein had to say:
I said that in this looser, more opportunistic environment I foresee the abandonment of the dreadful, depressing, defaulting process of putting managers into cubbyholes — large-cap growth, small-cap value and such foolishness — along with this stifling, stupid obsession with tracking error instead of absolute results and risks incurred…
To me, the bogey is not what somebody else is doing. It is what do I need for what I hope to achieve, or do in my retirement, or to fund my grants or to keep the faculty happy. I need a return of such and such and I can stand just about this much volatility. How much is this manager contributing toward that goal? The volatility is tricky because it can be very volatile, if it’s got a low covariance. But when I look at my portfolio, how much is this manager helping me to get where I’m going? My question isn’t whether they are beating the S&P or the Russell, but how am I doing? I happen to be rereading some Benjamin Graham from the 1950s, and one of the things he stressed is that the market is only interesting if it’s going up a lot and you want to sell. Or going down and you want to buy. But what other people are doing in the market is not relevant to what you’re doing. He emphasizes that over and over again. Once you get in the benchmark business, you’re asking the question differently.
“How am I doing, relative to how other people are doing,” blah, blah. It’s not interesting. Selecting managers is difficult enough, so that if somebody is delivering for you and helping you get where you need to go and the relationship works, I don’t care where he ranks, because the ranks change.
Maybe I’m wrong, but it’s going back to first principles, and that’s always a good idea.
Throw Out the Rulebook
- The Psychology of Prediction – M. Housel
- Investment Risk is a Behavioural Phenomenon Not Just a Number – Behavioral Investment
- How I Spotted a Fraud (Before It Was Too Late) – Behavioral Value Investor
- Why Boring Stocks are Beautiful (and May be Risky Today) – Intrinsic Investing
- Value Investing & Concentration – Alpha Architect
- How Leverage Turns Market Corrections into Crashes – Yale Insights
- The Logic Behind Bonds that Eat Your Money – Businessweek
- Negative Interest Rates: Carry an Umbrella at All Times – Enterprising Investor
- The Science of Regrettable Decisions – Vox
- Chris Davis: Investing with Curiosity (podcast) – Value Investing with Legends
- Eric Sorensen: How Quant Evolves (podcast) – Invest Like the Best