Whilst reading Seth Klarman (Trades, Portfolio)’s "Margin of Safety," I came across his description of relative vs. absolute performance.
Klarman believes that one of the big reasons why so many investors underperform is that they measure their performance in relative terms. How often do you hear a fund boasting of beating the market, or a strategy keeping track with an index? The appeal of such marketing is obvious: everyone wants to believe that they are better than their competition, or at least better than average.
Of course, in the larger picture, relative outperformance means nothing - what you want is to book absolute gains.
Investors that benchmark themselves against some competitor will inevitably find themselves in the position of reaching for returns that may carry with them excess risk. By contrast, investors that measure themselves in terms of absolute gains have the luxury of sitting back and waiting for the right opportunities to come up. Value investors are, almost by definition, absolute return oriented. They purchase undervalued securities and sell overvalued ones. If all securities in a market are overvalued - as often happens at the top of a bull market - they will not invest. This will lead them to underperform the market in certain years, but to an absolutist this makes no difference. As Klarman explained:
“Absolute-performance-oriented investors usually take a longer-term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results. They make actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term underperformance. By contrast, [absolutists] are likely to prefer out-of-favour holdings that may take longer to come to fruition but also carry less risk of loss”.
What Klarman is saying, in effect, is that there are opportunities out there that are being passed over by investors simply because they are worried it will take too long for them to rise in price. This probably explains why over the last decade-plus, so many more investors have been drawn to growth investing.
For one, it is psychologically pleasant to invest in a stock that is going up and will continue going up, rather than buying a beaten down company that may fall further and that everyone is skeptical of. Secondly, the false assurance that the growth stock will continue to rise indefinitely satisfies relative performance oriented investors. This is a textbook example of speculative thinking; more and more investors become drawn to the carrot of easy gains and run from the stick of relative underperformance. With such a setup, it’s no wonder that bubbles form and burst so regularly.
Disclosure: The author owns no stocks mentioned.
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