Are You 'Relatively' Successful? There's A Smarter Way To Invest...

Includes: DIA, IWM, QQQ, SPY, TDIV
by: Joseph L. Shaefer

Are you one of those investors whose only goal is "to beat the market?" That feels pretty satisfying when the market is up 10% and you are up 15%. But what happens when it declines 10%? Are you pleased that you "only" lost 5%? The problem with seeking relative returns is that you have no touchstone for your portfolio or your goals. You are merely trying to be the hero with your hands held high on the roller-coaster - until you are so terrified you are gripping the safety bar with white knuckles.

Would you rather retire with substantial assets (and substantial cash flow from those assets?) Then you need to achieve absolute returns, not relative returns. Those speculators who are upset when they "miss" some part of a 30% up year and driven to tears when they lose money the next year are and will always be on both an emotional and a financial roller-coaster. If, instead, you are willing to pursue your goals with an attempt to be worth more at the end of every year than you were at its beginning, neither event will make you tear your hair out. Every year, you'll be looking to see steady progress toward your goals, regardless of how much above or below the market you are. And with a more realistic plan to average 7%-9% per year over any reasonable time frame, you'll sleep much better, as well.

As portfolio managers, we like to see absolute returns, not relative returns, even if we are "beaten" by the market some years and "beat the market" in other years. If you manage your own portfolio, you might also want to see as steady as possible a march toward your long-term goals. Most investors do not do this. When you ask what their goal is, they respond, "Make more money." They have no idea how much money they will need for their retirement, college, charitable or other goal. When asked, they typically respond, "As much as possible." That isn't a goal, it's a hope without a plan.

When asked what their plan is to make as much money as they can, the response is some variation of "buy the stocks that go up the most." That's every bit as helpful as Will Rogers' monologue about then President Coolidge (who never actually said these words!) "Buy good stocks and sell them when they go up. If they don't go up, don't buy them." What kind of assets will you hold, in what mix, and for how long? What will lead you to buy? When will you sell? Without asking yourself those kinds of questions, Will Rogers advice will be your plan and your goal.

(Interestingly enough, this is partly a gender issue. Those who want to "beat the market" are mostly competitive men; those who are delighted to see incremental increases on a more regular, steady and, if need be, slower trajectory are mostly women, particularly women who do not "play" the market or unduly concern themselves with its daily gyrations.)

As absolute return investors, we are aware that there will be periods when we provide more than the return we have targeted as being reasonable and safe, and periods when we will provide less. That's OK. We keep our eye on the prize; that is to say, we have a goal and we have a plan to reach that goal.

If someone is focused only on what the market does today or this month or this year, they've taken their eye off the prize. Yes, all these little iterations called cyclical movements in the market add up to something -- but the Something to focus our attention on is rather more straightforward: "Am I making progress toward my goal of having "x" dollars for retirement every year or am I merely along for the ride wherever the market leads?"

For absolute return investors, it is the steady progression that counts. Seeking absolute returns doesn't mean you will always stay above water every year, of course, but the goal is to make up for any down year not by choosing a more speculative path the next year, but by hewing to the path you have set for yourself knowing that, by sticking to top quality and seeking good income from the companies whose equities you own, you are likely to see returns well above your objective goal in recovery and bull market years.

So what would I consider a great year or a terrible year for an absolute return portfolio? For me, a great year is any year I either beat my 8% - 10% per annum target, do well enough to make up for a prior year when I did not reach 8%, or "bank" a 15% or 20% return against the inevitable year I don't reach that target. A terrible year, for me, is one in which I don't continue my forward progress along the trendline to ultimately doubling and tripling my family's and our clients' net worth.

I've created the chart below to show how an absolute return investor would fare if they steadily gained 8% every year, taking as my cue a typical advisory client who invests $500,000 and wants to achieve an 8% or better return for 12 years.

Of course, in the real world, the market fluctuates! But if this investor "averaged" a reasonable return of 8% per year (which seems paltry to relative return investors who saw 30% in 2013,) their $500,000 becomes $1,259,085 at the end of their 12-year time frame.

If they continue to keep it invested and earn that rate of return, the power of compounding continues:

As you can see, it would take the absolute return slowpokes 21 years to get there. On the other hand, they will quintuple their investment simply by the power of compound investing, keeping a steady hand on the tiller, and never losing sight of their long-term goal. Ask yourself, "By following every blip in the market, reading every news headline, scanning every guru's opinion, and faithfully watching CNBC, did I quintuple my portfolio over the previous 21 years?"

Warren Buffett says he has two rules in investing:

Rule #1: Don't lose money.

Rule #2: See Rule #1.

Investors who seek absolute returns keep this mantra uppermost in mind. They might endure a stretch of as long as 3 or 4 years where they lose or only maintain but, over time, they are so risk-averse that they always come back and revert to the mean compound return rates as exemplified by these two charts.

The way I choose to achieve my own absolute return goals is to buy at a reasonable price the most dependable dividend-paying companies I can find that also have a history of consistently raising those dividends. I am willing to reallocate assets if I believe, using common sense and discipline (not some black box computer model or a static percentage decline!) that one of my companies has gotten ahead of itself.

If you like this quality-company, growing-dividend approach, you might conduct your own due diligence today on some of our favorites like IBM, Cisco, Oracle, Intel and Microsoft to see if you agree they are stellar choices at these prices. Or, if you want to dip a toe in this pond, you might consider the First Trust NASDAQ Technology Dividend ETF (TDIV.) Its largest holdings are Intel, Cisco, IBM, Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Oracle (NYSE:ORCL) and Qualcomm (NASDAQ:QCOM). And for more on why you shouldn't panic just because the market is down so far in 2014, you might want to check my thoughts on "controlled burns" in the markets here!

An absolute return strategy ignores distracting market fluctuations. Remember: the market giveth and the market taketh away... but nobody knoweth in advance whether the taketh-away period is just a minor correction or the real thing, until the devastation has been wrought. So we absolute return investors just keep plugging away, crawling steadily ahead like the tortoise. It's a bit dull, true, but we still get our market thrills… by watching the hares bouncing around in all directions.

The Fine Print: As Registered Investment Advisors, we believe it is our responsibility to advise that we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund one year only to watch it plummet the following year.

We encourage you to do your own research on issues we discuss to see if they might be of value in your own investing. We take our responsibility to offer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we "eat our own cooking," but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Disclosure: I am long IBM, CSCO, ORCL, MSFT, INTC, TDIV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.