One of the great ironies in the hedge fund industry is the propensity for many investors to favor relative returns over absolute returns.  This is particularly true among retail investors who, by and large, would prefer to lose money along with everyone else than to make less than everyone else.  What else could explain the complacency with which investors accept -40% market returns while crying foul at the hedge funds that “under perform” in a bull market.

Research into happiness has dispelled the notion that utility is derived from some absolute level of wealth.  Instead, it appears that utility is relative, not absolute – hence the paradox of the retail investor who is petrified of under performing his neighbours, but sanguine about losing his shirt alongside them.

More than some esoteric argument, the phenomenon of relative wealth may actually account for the overwhelming amount of empirical evidence than seems to refute the hallowed Capital Asset Pricing Model.  In a paper released last month based on his new book “Finding Alpha“, author Erik Falkenstein argues that: More…