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Measuring Performance - Absolute vs Relative Performance
Institutional investors as well as individual investors tend to measure their performance against "the market." Today, I'll make the argument that this hurts your investment returns.
What is “The Market”
The Disadvantages of the “Beating the Market Mentality”
Bad Absolute Market Performance
There seems to be only one correct way to measure your Portfolio’s return. You compare it to the market. In the end, that’s the alternative you have—a passive investment into the market.
But what even is the market?
What is "The Market?”
Is it the S&P 500? The MSCI World? Your major national stock index?
There isn’t “the market.” There are a lot of indices that can be used to compare your results against. And if you want to, you can choose another index every year and make sure you beat “the market.”
You could also figure out which index performed the best every year and compare to that one if you like the challenge. Or, the best out of these options, you use the same one every year. An index that fits your investment strategy. If you invest in tech stocks, you might choose the Nasdaq. If you invest in companies of all sizes worldwide, you could go with the MSCI World.
But whatever way you go, comparisons based on who beat the market are still imprecise if everyone aims to beat another market. If you compare performances between investors, you can’t use their yardsticks for the comparison. You need the same index for everyone. And even then, you neglect how much risk someone took to achieve his or her returns.
But besides that, today, I’ll tell you why comparing your returns to the index isn’t a good idea in the first place and actually hurts your investment performance in the long term.
The Disadvantages of the Beating the Market Mentality
One of the biggest problems with focusing on beating the market is the short-term perspective you inevitably end up in. Institutional investors have to compare themselves with the market (their yardstick) on a monthly or quarterly basis. But even if you do it only at the end of every year, you limit your investment horizon to an annual basis.
Some of the best investments, however, need time to play out. According to Benjamin Graham and other successful value investors, many undervalued opportunities will correct themselves within a three-year time span (If there’s no catalyst). If you only think on an annual basis, you won’t participate in these opportunities.
Instead, you are more likely to take risks that you wouldn’t take otherwise in the hope of reaching your goal of beating the market in a given year. That’s the exact opposite of what you want to do as an investor. You want to “pick the battles” that benefit you. Only swing at opportunities that offer an asymmetrical risk-reward ratio. The pressure to beat the market, however, makes you ignore the advantage of being able to choose your battles and instead forces you into suboptimal bets where risk and reward balance out, or worse.
Another crucial point linked to a short-term perspective is the acceptance of near-term underperformance. If you invest in companies that offer great returns but take months or even years to play out, you underperform in the near term to outperform in the long term.
When I say this, you might realize that I still end up talking about outperformance of the market. The big difference is whether you make it your investment maxim to beat it or just accept the fact that there is an alternative to invest in.
More on that in the conclusion, let’s focus on the other disadvantages first.
The big advantage individual investors have over institutional ones is the ability to deviate from the market. Institutional investors can’t do that because of so-called “career risk.”
If they deviate from the index they compare against, there are two options. They either perform a lot better and get praised. Or they underperform and risk their job. While the first option is great, sooner or later, you’ll have a bad year or two and underperform. And if you do that while deviating from the market, and thereby also from all your competitors since they will all be highly correlated with the market, you look very, very bad and probably lose your job. The years of outperformance are forgotten pretty quickly then.
By owning portfolios that are more or less the same as the market, however, you’ll never underperform so badly that you’ll lose your job. You might underperform by 1% in one year and then outperform by 1% the next due to over- or underweighting of certain stocks or sectors. Either way, you hide behind the correlation with the market.
The big opportunities are outside of the well-known stocks of the indexes, however. Those areas are less efficient, overlooked, and illiquid. In short, investing there will make your performance deviate from the market. Of course, this can go both ways. When there is the opportunity for outperformance, there is also the opportunity for underperformance.
But you can choose the investments that you consider to have the best outlook and match your strategy the best. You are not bound to a limited pool of companies or a limited timeframe to deliver your performance.
Bad Absolute Market Performance
Last but not least, what do you do when the market isn’t performing as well as it did over the last decade? Would you be happy with a 5% return over the next five years because the market only did 3%?
Wouldn’t it make more sense to aim for 10% a year, neglecting whether the market goes up 15% or loses 2%?
Once again, by deviating from the market, you can pick stocks that are uncorrelated enough to go up 20% when the market is down. If you have a highly correlated portfolio, you can’t do that. You inevitably follow the market's return. If the market is weak, so are you.
The problem is the “Beating the Market Mindset” that pressures you into short-term thinking, risk-taking, and conformity. Over the course of your entire investing career, the assessment of whether you were successful or not, also depends on whether you beat the market/alternative ways to invest your money (Other factors, like enjoying what you did, etc., also play a role, though). But if you focus on this while in the game, you limit yourself to the market’s performance.
If that’s what you want, you can invest passively in the market. Nothing wrong with that. But if you choose to invest actively, you should ignore the urge to compare yourself with the market completely and only focus on absolute returns.
That’s it for today! I hope you enjoyed it, and have a great Sunday!
I will see you in a week!
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