How soon people forget about the flip side of returns.* “The markets have been up for a while now.” “My accounts are up.” And many other similar statements are heard about markets and accounts. A sigh of relief (emotion).
And the the insidious happens! You start comparing what has gone up the most (emotion – greed). Look at that fund, it’s up more than this other fund. I should change to “that” fund because it is up more. This kind of thinking has many layers of faulty thinking based on emotion.
First. Are those two funds even comparable? Apples to oranges, or apples to apples? How do you know? Look deeper at what each uses for a benchmark (index). If the benchmark index is the same then you have an apples to apples comparison and the differences between the two funds is a function of type and weighting of the companies in the fund (i.e., those allocation differences would explain the returns differences). If the indexes are not the same, you can’t use returns as a comparison because the makeup of the two funds are different to begin with.
Second, *that flip side to returns is called risk. The higher the returns, the greater the risk since they go hand in hand. Risk in general here refers to the level of volatility. So you might seek the big returns number, but are you ready for the big risk (volatility) number too?
Third, you can’t compare an overall return of your portfolio made up of multiple funds to the return of a single fund. Why? Because the overall return of your portfolio is a weighted average of all the returns within your portfolio. This means something in your portfolio had a greater return than the overall portfolio return, and something in your portfolio had a lower relative return during the period reported. During past periods, odds are your returns came from different funds within your portfolio than now, and other periods came from still different funds than those. In other words, everything keeps changing.
One way to help – invest in indexed funds. This way you know you are getting closer returns to the benchmark to begin with (at least within the margins of the indexed fund’s tracking error (wikipedia on tracking error)). This is why I suggest indexed, or passive indexed, funds. Research over many years suggests you receive more consistent market results. Note: market results go up and down – so I am NOT saying consistent returns … I’m saying returns closer to what the market gives … “be the market” instead of “beat the market.”
The real metric you should be using is whether you are on track to reach your goals. Chasing returns simply means that you are trying to make the market (what you can’t control) do most of the heavy lifting … when in truth what determines your success is how much you save (or withdraw if already retired). In other words you can control how much you save or spend … not the markets or the economy.
Profits affect the economy and profits are the sum result of all our actions. Profit expectations are part of what forms stock prices. The stock markets are the sum of all of our expectations as buyers and sellers trade their shares based on their expectations (note: there is a buyer and seller who tend to have different expectations about the very same thing one is buying and the other is selling). There is a virtual circle of connections between all these activities that feedback on expectations as a result. How do you personally control any of that … especially when everyone else is trying to do the same? You can’t. This is why you always see this statement: Past returns are not predictive of future results.
The opposite of greed is panic. Notice how people have gone from panic to greed lately? And just wait … that will change when the mood and expectations suddenly change. Emotions are how we process both the economy and the markets. Both emotions should be recognized and managed for their dangers. Emotions get in your way – too much risk when you shouldn’t and not enough when you should (Cycle of emotions).
Thus, chasing returns puts you on a slippery slope. The higher you reach the greater the slip and fall. Best to simply structure things with a broader perspective (your goal) and design your affairs to prudently meet your goals … BY STAYING CONSISTENT.
By staying consistent, you stay on level ground. You don’t put yourself on a steeper and steeper slope.
Learn to set the sails since you can’t control the wind or the currents … and you can reach your destination.