When evaluating the performance of your investment portfolio, first you need to decide what is important. Are you trying to outperform an index by using actively managed funds or buying individual stocks? Or, do you have a specific rate of return you want each year? Deciding between the two will help you determine the type of investments to use, and if you need to use different fund managers or a different strategy.
Relative Return
Say you use actively managed mutual funds because you think they can do better than the market/index. Those managers are trying to beat a “benchmark index” which is comparable to their fund strategy. Through February 28, 2009 the Fidelity Magellan Fund was down 51.75% while the benchmark it compares itself to, the S&P 500, was down 43.32%. So, the relative return of Fidelity Magellan is negative 8.43%. The manager’s goal is to always beat the benchmark, not necessarily to have positive returns.
Many brokers focus on relative return because they have big egos and want to be the “best.” This can be in conflict to what clients want because the broker may take more risk than the client wants in the form of concentrated asset classes, active trading and chasing past performance.
Absolute Return
Hedge funds, college endowments at Yale and Harvard and certain financial advisors use absolute return to measure their performance. They start with a target rate of return to meet objectives, say 8%, then allocate assets in a way they believe will accomplish this goal. The return received in a specific period of time is absolute return. Ultimately, the goal is to always have positive returns.
Absolute return is most often accomplished by using a highly diversified mix of asset classes. Asset classes include stocks, bonds, commodities, currencies, private equity, and real estate. By inputting average returns over long periods of time a person can manage the risk they take and the amount they will accumulate over time.