Financial professionals understand the difference between “Absolute” returns and “Relative” returns. In the professional world of investing, absolute returns mean very little. With most of the investing public, absolute returns mean everything! This creates conflict that can be costly for consumers.
A common, but utterly meaningless question asked by consumers of a professional is, “What has been your rate of return?” This question is loaded with compliance concerns and effectively impossible for any reputable advisor to answer without misleading the questioner! If an advisor actually gives you a specific rate of return percentage, you should run looking for another advisor.
I recognize the question feels like a natural question to ask, but consider the absurdity of asking? This question is asked of an advisor who knows very little to nothing about your situation or risk tolerance at the time you ask. To provide an answer, the advisor would have admit to having a “one size fits all” portfolio he or she is selling without regard to anything unique about your situation.
If an advisor gave you a rate of return percentage you liked, how would you know it is true? There are likely many undisclosed footnotes to the answer. Additionally, is your sole criteria for advisor selection based on how this question is answered? At PCA, we don’t have any two clients with the same rate of return. Our objective is to provide each client with a rate of return as good as they choose! This is done by seeking Alpha. The excess return of an investment relative to the return of a benchmark index is the investment’s Alpha.
Let’s take a closer look at Absolute versus Relative returns and Alpha. If you chose to put 100% of your money in the stock market, then your chosen rate of return will be what the stock market does (for better or worse). In 2017, your Absolute return might be positive 20% while your 2008 Absolute return might have been negative 37%. At our firm, we seek to earn our clients a strong relative return at all times regardless of whether it is a bull market or a bear market.
If a client earns 22% from their stock allocation, versus 20%, then the client is benefitting from 2% Alpha. Similarly, if the client lost 28% in 2008 on their stock market allocation, then the Alpha earned that year would have been a phenomenal 9%! This would be a fantastic Relative return (+9%), while still being a poor Absolute return (-28%). Over the long haul, a positive Relative return is what makes you money. Alpha is everything to Professionals.
Our PCA Investment Policy Committee meets quarterly to assess the relative return of investments within their asset class. When your stock fund is down, we want it to be down less than the stock index. When your bond fund is up, we want it to be up more than the bond index. This disciplined approach to seeking Alpha is applied to Small Cap, Mid Cap, Large Cap, International, Emerging Markets, Commodities, etc. etc. etc. on a quarterly basis.
In choosing an advisor, a consumer is much better served asking “what is your investment selection process?” versus asking “what has been your rate of return?”. A client’s rate of return is derived from how and why they are invested in a particular allocation. Working backward, a client is invested in a certain allocation because they have chosen to be invested in a certain allocation based on their unique objectives. This requires significant questioning and consideration with a competent advisor.
The result for our clients is that they likely get a return as good as they choose based on their risk allocation. This may be a negative Absolute return or a positive Absolute return. Short-term performance (1-5 years) will never be predictable, but long-term performance has proven to be quite consistent.
Clear as mud now? Your feedback is always greatly appreciated!