Tuesday, January 5, 2010

The Backward Investor

Would you rather make 18% in a year on your investment or lose 33% in a year on your investments? Believe it or not there is a subset of investors who would prefer to lose 33% rather than gain 18% on their investments. Let me clarify. The Standard and Poors (S&P) 500 index went down 38.49% (excluding dividends) in 2008. This past year, in 2009, the S&P 500 gained 23.45%. There is a subset of investors who strive to "beat the S&P 500." This perverse group of people would be thrilled to have lost only 33% of their money in 2008 because they would have beaten the S&P 500 by over 5%. This is referred to as "generating positive alpha". (If you didn't invest in the stock market at all and ended up with a 0% return, you would have beaten the S&P 500 by 38% in 2008, and generated 38% positive alpha by doing nothing.) In either case, I didn't exactly see many people celebrating their investment portfolios in 2008.

By contrast, these same folks would be bummed out to make only 18% on their investments last year in 2009 because they would have underperformed the S&P 500 by more than 5%. I don't know about you, but I would happy to make 18% in a year on my investments, and would feel ashamed if I had lost 33% in my investments (regardless of how badly the rest of the market is doing). The truth be told, I used to compare my stock performance against the S&P. After I saw how ridiculous that comparison can be, I don't do that anymore. This reminds me of the "keeping up with the Joneses" comparison in personal finance. My advice is not to constantly compare your portfolio performance with the S&P, Nasdaq, or your neighbors. Instead, strive to improve your own position year over year.

My final comment is directed to those who still believe that comparing against the S&P 500 index or investing in S&P 500 index funds is a good idea. For the 10-year period ending on December 31, 2009, the S&P 500 index lost 24.1% (excluding dividends). That ought to give you something to think about.



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