Its All Relative


In 1905 at the age of 26 an obscure patent clerk in Berlin, Germany published four scientific papers that would literally turn the scientific world upside down and inside out. Of course, I am referring to none other than Albert Einstein. And while the intellectual density of his work goes far above my head, I can appreciate one concept he introduced: it’s all relative. Einstein’s work made us reexamine time and space, and to consider that nothing is finite, and nothing is constant. (Other than the speed of light!)

Special Relativity was not part of my curriculum when I studied finance in college. However, the idea that reality cannot be assessed without some perspective was always present. For example, most investment managers use a benchmark (think, S&P 500, or some other index) to measure their performance. The difference between a manager’s performance and the benchmark is commonly referred to as alpha. Financial relativity is also found in the term beta, a measure of an asset’s risk in relation to the market. And there are many ratios (which are inherently relative) that are used to evaluate an investment’s merits. One of the most common ratios is named after William Sharpe who developed it in 1966. Here, the Sharpe Ratio shows an investment’s “risk adjusted return” or the return an investor receives per unit of risk.

Investments are not the only area of finance that use context to answer questions. Holistic financial planning also requires perspective. Most people want to know if they are saving enough for retirement. The only way to answer that is to analyze the person’s savings rate in the context of their goals. If you want to travel the world in retirement, then you might need to increase your savings. However, if your main goal in retirement is to tend to your garden then you might be saving enough. It’s all relative.