The Stock Surfer

Avoid The Illusion Of Relative Returns

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Investors are being disabused of many conventional notions this year. If the first giant to fall was "buy and hold", the second should be the idea of relative returns. Relative returns make us feel good, but they can be quite dangerous. Here's why.

Mutual fund companies have sold us the idea of relative returns because it makes them look good. They want to show that they can beat the market (although they remind us that this is only for professionals). So they take a market index like the S&P 500, and use that as a measuring stick for their fund. If the S&P 500 is up 10% in a year, a mutual fund wants to be up more than 10% in that same year. And I would agree, that's a good return. But the situation is not so rosy when the market is down. If the S&P 500 is down 42% (as it is this year), a mutual fund might brag that it is only down 35%. Sure, they beat an index fund by 7% (not including loads and fees, of course), but so what? You're still down 35%! Down 35% is not a good return.

I'm not saying it's easy to get a positive return. Most people, including me, are down this year. But in a bear market, relative returns can't buy you a cup of coffee. It's time to think from a different perspective strategically. It's time to think about absolute returns.

Focusing on absolute returns helps an investor's psyche because it doesn't play the game of chasing winners or holding losers. If I'm worried about relative returns, I might be inclined to carelessly chase a rally even though I know it won't last, or stubbornly hold a loser as long as it's doing better than the Dow. I might avoid taking profits (i.e. making money) because I want to beat the market.

If I don't care about relative returns, I can simply focus on making money. When I make a trade, I'm looking to cut my losers so I don't lose money. If a trade is working, I'm looking to maximize gains in my account, not on paper. I think most people tend to run their portfolios like a mutual fund because they've absorbed the conventional wisdom of buy and hold along with relative returns. I used to do this. But I think there's a better way. I'm still learning about absolute returns, but here are some initial thoughts to get started.

HOW TO GET ABSOLUTE RETURNS

Cut losers quickly. This is rule #1. Absolute returns is all about avoiding big losses. If you are holding a stock and waiting for it to come back, ask yourself this question: Of all the investments available to me right now, is this stock the best opportunity for me to make money in a reasonable timeframe? If the answer to that question is no, sell that stock ASAP and put your money where you can get a positive return. Why hold Citigroup (C) when you can buy Amgen (AMGN)? (click chart to enlarge)

Look at the big picture. Absolute returns means you need to look at more than just your stocks. You need to look at overall net worth. If you are holding debt at 7%, and making market returns of 5%, that's a return of -2%. You may not be able to avoid all debt (if you have a mortgage, for example), but if we've learned anything from this crisis, it's that profits are fleeting if we can't handle our debts.

Consider alternative investments. Perhaps you are comfortable with mutual funds or stocks. That's okay, but we've also learned that stocks around the world have provided very little benefit in terms of diversification. Stocks of every size, shape, and nationality have been going down. Exchange Traded Funds (ETFs) make it easy to try different asset classes. You can buy the dollar (UUP) or gold (GLD) or natural gas (UNG), or you can short those same assets. You can also short the market through ETFs like the short Dow (DOG). The point is, being long a bunch of different stocks may not help get you absolute returns, but there are other options out there for your money. (click chart to enlarge)

[Disclosure: Long AMGN.]