Most mutual fund investors fail to outperform the S&P 500 index over the long-term, after expenses are factored in. They accept this sub-par performance year in and year out without considering alternatives -- and the best one is index funds.
This acceptance comes from investors focusing on relative performance, when in fact, successful investors focus on absolute returns.
Market returns should not dictate your decisions
Investors who consider relative performance compare their results to the market's, or worse, other investors'. For good relative performance, they concentrate on imitating or outguessing others, and doing so, their efforts shift away from buying undervalued securities to an approach dictated by someone else.
Absolute performance, on the other hand, focuses investors on long-term results. Undervalued securities are purchased without considering market sentiment and instead on their own merits.
So undervalued securities often don't move in sync with the overall market. Absolute performance may result in an underperformance relative to the market indices, because those investors wait while the rest of the market is climbing.
Recipe for mistakes
Costly mistakes can happen when investors chase short-term relative performance benchmarks. Looking back at the dot-com bubble illustrates this point perfectly.
The news stories of individuals with no investing experience earning triple-digit returns inspired small and big investors alike to invest in anything rather than invest soundly. Instead of waiting for the right time, investors poured good money after bad in an effort to produce results like everyone else's, without considering fundamental analysis.
It didn't matter that companies like Amazon.com, (Nasdaq: AMZN ) and Cisco (Nasdaq: CSCO ) were not making profits in 2001, while others like Yahoo! (Nasdaq: YHOO ) were earning a few cents per share. What mattered was that idle cash was useless because it was underperforming a rising market.
Patient, value-focused investors, on the other hand, waited -- with their cash -- for the excess to play out before making a move. Remember all those Internet mutual funds with triple-digit returns in 1999 and 2000? They soon discovered the results of chasing momentum with staggering losses when the bubble burst.
When you focus on absolute returns, your approach is guided by the availability of undervalued investments. If no bargains exist, then cash is your best friend.
Warren Buffett endured ridicule during the Internet bubble for not joining the party. Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) was spotlighted for its "relative underperformance" during the dot-com boom, because it didn't use its enormous cash pile to chase easy profits. Then, like now, Berkshire seems to be enjoying the last laugh.
You're an investor, not an imitator
While I certainly advocate analyzing what top money managers are buying, one should use this information as an excellent source of ideas. Investors have their own circle of competencies, and for the most part, copying an investor does not produce similar results.
Take those ideas and analyze them yourself. If you like what you see and can understand why it is a good undervalued company, you can then take advantage of the opportunity. Just never forget that imitation will take you only so far.