You may have come across the terms “absolute” and “relative” returns.
Relative return is the percentage of return from an asset (or investment) over a time period compared to a benchmark such as an index. In investment management, relative return is used as yardstick more frequently than absolute. This is a shame, and here’s why.
Weighing Probabilities
Nobody knows where the indices will be heading. Whether you are a bull or a bear, you’ll find news and data confirming your held beliefs.
As an intelligent investor, you need to look at investments on an individual level, and ask yourself: “Is the probability of permanent loss low, with a large enough margin of safety for substantial gain if I’m correct?”. If you corrupt your mind into relative return thinking, you increase the odds of an unfavorable outcome.
If you think in relative returns and you believe the S&P 500 is set to rally 10% this year, all your investment decisions will be biased towards what you can gain, instead of what you can loose. This approach may work, but now you’re automatically part of the crowd in your thinking. The crowd gives a feeling of safety, and will confirm your beliefs. There is nothing inherently wrong with this, it’s in our nature.
The problem is that by design, the crowd has already priced a stock with a bias towards a favorable outcome. Recent gains are extrapolated far into the future, and your odds of gaining outsized returns will keep diminishing as the crowd grows larger. This sets the stage for a decline and when it eventually happens, is your conviction stronger or weaker? Successful investing requires a psychological makeup which most people don’t have. This is why I recommend indexing for the vast majority of people.
Low Prices Require Bad News
The age old adage “buy low, sell high” has always been true. Yet, investors don’t behave in this manner (though most believe they do). In order to adhere to this, you need to buy stocks when they are unloved by the crowd, and sell when they are dear. A stock that is cheap is almost always coupled with bad news. You cannot have good news and cheap prices. Companies that meet your investment criteria need to be evaluated on their individual merits. Are you looking at a permanent decline or is the bad news temporary in nature?
Get used to looking at situations that look bleak on the surface. Your mind should be wired in a way that it gets more excited over a fallen stock, rather than one that’s gained. During the Bear Market of 1973-1975, the Oracle of Omaha was asked how he felt on the situation. Here’s what he said, and a true value investor would say the same:
“Like an oversexed guy in a harem” – Warren Buffett. Forbes, 1974.
Conclusion: Do Nothing
This blog is called Ignore The Street for a reason. The street is the crowd. The place you wan’t to avoid. As Howard Marks says, “You cannot only think differently, you also need to think better”. So how do you think better?
In order to think better, you need to stick to mental models. Here are three which I have written about:
Investing is a game of probabilities. If you wan’t different results from the crowd, you need to divert from the crowd. This may be in actions, but often times it is in inaction.
If there’s nothing smart to do, it’s better to do nothing.
To end this post, I’ll let the head of Greenlight Capital summarize:
“In assessing an investment opportunity, a relative return investor asks: “Will this investment outperform my benchmark?” in contrast an absolute return investor asks, “Does the reward of this investment outweigh the risk?”. This leads to a completely different analytical framework. As a result both investors might look at the same situation and come to opposite conclusions”. -David Einhorn.
The ongoing pandemic has the world’s economies shaking, but times like these create the best bargains.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
