When you consider investing in the market, your mind probably goes to low-cost index funds. Even a small amount of money can be invested and gain exposure to a significant amount of diversification.
In the words of Warren Buffett, “Diversification is only required when the investors do not understand what they are doing.” For those who don’t have time to research each investment or don’t want to manage their portfolio on a daily basis, buying and holding low-cost mutual funds and ETFs can be a great option.
This strategy is based on what is called “relative return theory.” Simply put, relative returns refer to placing assets in a fund, whether it is a mutual fund or an ETF, that mimics, for better or for worse, the performance of an index like the S&P 500. Whatever the S&P 500 does, in this example, is similar to what you get. The return is relative.
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
However, there is a different way to look at the markets and your returns. Many do not know it exists. I’m not saying it is better or worse than relative return investment strategies. My purpose in writing this article is to introduce this alternative investment theory so you can decide whether it is right for you.
What is absolute return theory?
In a nutshell, absolute return seeks to make money during a specific period of time, regardless of market conditions. Admittedly, it is easier said than done. I am not claiming that anyone can successfully time the market. The data is clear that it is generally better to have time in the market than try to time the market.
I am not claiming that “absolute return” means “absolute positive return” or “absolute guaranteed return.” Investment models based on absolute return theory can produce negative returns, just like relative returns. All I’m suggesting is that there is a different way to look at the market and your investments.
Absolute return is a more intentional and sophisticated approach to investing. If you take a close look at different hedge funds or endowments, such as the Yale Endowment, you will find a significant portion of their portfolio is dedicated to absolute return. Normally, absolute return models consist of options, derivatives, leverage, short selling, futures and other unconventional assets. These instruments may not be appropriate for the typical investor. Also, many Americans can’t meet the often multimillion-dollar account minimums to get access to these sophisticated models.
However, absolute return theory isn’t reserved only for the ultra-wealthy. Here are three examples of how you can implement absolute return theory into your portfolio:
1. Quality over quantity
You probably don’t need all 500 stocks in the S&P 500 and all 2,000 stocks in the Russell 2000 in order to have a good portfolio. Instead, pick the stocks of good companies that you understand and believe will do well over a long period of time.
As the late Charlie Munger put it, “The idea of excessive diversification is madness. Wide diversification, which necessarily includes investment in mediocre businesses, only guaranteed ordinary results.”
Pick what you know and understand. Then hold them. Your expected return should not be based on an annual basis. It must be based on a certain, predetermined period of time. Your stocks will most likely go up and down throughout the year. However, if they are good companies that offer good products and services, they offer the opportunity to eventually produce desirable results. You don’t need to be fancy, just deliberate.
2. Trend-following models
Within any given market, you can typically find a certain amount of momentum one way or another. Investors who subscribe to trend-following algorithms try to find and capture that momentum through signals. These signal-calling models typically take in information, like moving averages, market breadth, trade volume and so on, to attempt to quantify whether the investors should buy or sell a particular stock at a particular time or price. Some models may even tell you when to short a certain stock or fund (or purchase an inverse fund).
Unlike mutual funds and ETFs, these models can tell you when to go to cash. Remember, these models, like any other investment strategy in the market, can lose money. There are unique potential benefits and detriments (risks) that should be explored before implementing these types of models. Some money management firms, like my firm, Kedrec, have their own proprietary models. Other investors search places like Timer Trac to find managers who offer models directly to the public.
3. Multimarket diversification
Consider placing some of your assets in investments outside of the stock/bond market. For example, consider the alternative space, which includes real estate, private equity and more. J.P. Morgan Asset Management recently conducted a study that found that when investors allocated 30% of their typical stock/bond portfolio into alternative investments, historically speaking, it helped increase annualized returns while decreasing annualized volatility.
Past performance is not indicative of future results. It does present an interesting argument against the timeless 60/40 stock-bond split. Make sure you understand the technical side of alternative investments before investing.
In conclusion
No one knows the future. There’s nothing wrong with the relative return theory, in my opinion. However, it is important to at least understand that absolute return exists and that it is available to average investors, not just those who can afford the $2 million minimum. Making informed decisions about picking stocks you understand, or following signals you trust, or diversifying outside your typical markets may help support your long-term investment goals, even in a flat market cycle.
Investing involves risk, including possible loss of principal. No investment strategy can ensure a profit or guarantee against losses. This information is presented for educational purposes only and should not be construed as investment advice or a recommendation to your unique situation. Absolute return models involve unique risks, which you should review carefully before investing.
Investment advisory services are offered through Kedrec, LLC, a Kansas state Registered Investment Advisor.
Related Content
- Many Retirees Don’t Know About This Major Market Risk: Do You?
- Retirees’ Anti-Bucket List: 10 Experiences You Don’t Want
- Social Security Optimization If You Save More Than $250,000
- 1031 Exchange: Do You Know Your ‘Like-Kind’ Options?
- Four Historical Patterns in the Markets for Investors to Know
-
How Prepaid Verizon Phone Service Works and When It's a Smart ChoiceExplore the differences between Verizon Prepaid and Verizon Postpaid plans—costs, perks, flexibility, and when going prepaid makes sense.
-
Try This One-Minute Test to Uncover Hidden Health RisksFinding out this little-known fact about your body could reveal your risk of heart disease and more. It's a simple, free check for healthy aging.
-
Social Security Wisdom From a Financial Adviser Receiving Benefits HimselfYou don't know what you don't know, and with Social Security, that can be a costly problem for retirees — one that can last a lifetime.
-
Take It From a Tax Expert: The True Measure of Your Retirement Readiness Isn't the Size of Your Nest EggA sizable nest egg is a good start, but your plan should include two to five years of basic expenses in conservative, liquid accounts as a buffer against market volatility, inflation and taxes.
-
New Opportunity Zone Rules Triple Tax Benefits for Rural Investments: Here's Your 2027 StrategyNew IRS guidance just reshaped the opportunity zone landscape for 2027. Here's what high-net-worth investors need to know about the enhanced rural benefits.
-
The OBBB Ushers in a New Era of Energy Investing: What You Need to Know About Tax Breaks and MoreThe new tax law has changed the energy investing landscape with expanded incentives and permanent tax benefits for oil and gas production.
-
Ten Ways Family Offices Can Build Resilience in a Volatile WorldFamily offices are shifting their global investment priorities and goals in the face of uncertainty, volatile markets and the influence of younger generations.
-
Should Your Brokerage Firm Be Your Bookie? A Financial Professional Weighs InSome brokerage firms are promoting 'event contracts,' which are essentially yes-or-no wagers, blurring the lines between investing and gambling.
-
Supermarkets Have Become a Pickpockets' Paradise: How to Avoid Falling VictimSome stores regularly rearrange inventory with the aim of increasing purchases, and they're creating opportunities for thieves to steal from customers.
-
I'm a Wealth Adviser: These Are the Pros and Cons of Alternative Investments in Workplace Retirement AccountsWhile alternatives offer diversification and higher potential returns, including them in your workplace retirement plan would require careful consideration.
