Relative Return

It’s when Uncle Charlie finally leaves to go back home to Milwaukee from that...unruly Thanksgiving weekend. Annnnd it’s also an investment term.

Keyword: Relative.

You invested in Pull the Plugs, a company that sells a natural hair growth remedy, at $100 a share. Bought a thousand of them for a cool hundred grand. At the time, the S&P 500 index was at exactly 3,000. Over the course of 2 years, Pull the Plugs went from $100 to $120; it also paid a $2 a share dividend each year. So its total return to shareholders, taking the cash dividend and not reinvesting it was $124.

And note that reinvesting it would cloud things here. That is, Pull the Plugs paid 50 cents per quarter. Like…what if the shareholder took that 50 cents and invested it in the stock each quarter, so that the 50 cents went up along with the stock itself? Well, they would have had more stock after 2 years. And a total return of 125-ish, because that reinvested dividend would have compounded as well.

But, without getting too complex, the key element here is that, in those same 2 years, the S&P 500 went from 3,000 to 3,900. That is, it was up 30 percent. And the S&P 500 pays a small dividend as well, so the actual numbers were even slightly better. Think: up 34-ish percent.

So ignoring divs for now, because the dividend rates were about the same for Pull the Plugs as they were for the S&P 500, then that’s a market return of 30 percent in 2 years, versus Pull the Plugs, which returned only 20 percent. So your relative return on that 2-year period was a 90. Meaning that you returned only 90 percent of what the S&P 500 returned.

Or rather, your investment had a poor relative return against the market. Relative returns matter a lot, because the presumption runs that investors can always just buy an index fund and go play golf. For professional money managers to actually earn the fat salary and bonus money they are paid, they have to beat the market, i.e. outperform it on a relative basis.

Otherwise, how do they rationalize the fat fees they charge for managing the money? If they didn't beat that key index fund, then why wouldn’t investors just, well, buy index funds? Had Pull the Plugs gone to, say, $180 a share, i.e., being up 80 percent in 2 years, it’d have outpaced the S&P by 50 percent in that time period...and would have had a relative return of 150 after it’s absolute return of 180.

Make sense? Hopefully all this stuff isn’t making you, uh, pull your hair out.