Beware the Pitfalls of Relative Benchmarks

(Click image above to see short video clip)

Not unlike the hormone-induced singles you might observe at a bar 15 minutes before closing time, we humans have a tendency of falling into the trap of weighing decisions based on “relative” attractiveness.  While relative benchmarks are important tools, using them outside of an absolute framework can lead to a poor decision-making track record.

To illustrate the point, let’s focus on a hypothetical scenario of a well-known equity analyst touting his latest stock pick on a financial news network.  He sure sounds convincing.  After all the company has a solid track record, it trades at an earnings multiple of X while its peers trade at 2X, and it even has a stash of cash so large, Steve Jobs himself would blush.  But as the old saying goes, “looks can be deceiving.”  While company XYZ may be relatively attractive, the absence of an absolute framework could mean it is still a bad bet.

In our example highlighted above, while company XYZ has myriad attractive traits on a relative basis, it could still be a horrible bet in an absolute sense.  Forgetting to use an absolute framework could mean our analyst has overlooked the fact that the overall market is overvalued (e.g., stock bubble in ’00), or that company XYZ’s sector is headed for trouble (e.g., homebuilder in ’05), or even that company XYZ’s business model is broken (e.g., RIMM today).  Each of these scenarios could result in an ugly outcome.  In other words, successful decision making track records are almost always built on a strong foundation of both relative and absolute benchmarks.

So the next time you’re making an important decision, remember to take a step back from the trees and focus on the forest.  Otherwise you may end up like so many a repentant 20-somethings at 8 am on Sunday morning.