Yesterday I published my investment performance review for 2017 and in it I mentioned my portfolio’s one-year performance since the start of 2017.
That was a mistake.
To be honest, I have gone off the idea of tracking one-year returns. I have always been against tracking short-term performance, but in the past just went along with what pretty much everyone else had always done, which is to talk about results over the last year (calendar or rolling).
But having recently read an excellent 2016 review and rant against tracking short-term performance, as well as The People’s Trust’s commitment to target returns over a seven-year period, I have decided to ditch what is essentially an unhealthy and pointless habit.
Most stock market investors know it’s daft to worry about whether their portfolio beat the market yesterday, last week or last month.
It’s daft because the market is noisy, and returns over shorter periods are driven by random fluctuations rather than any inherent strength in a company, portfolio or investment strategy.
The same logic against measuring returns over a day, week or month extends to measuring results over a single year.
And I still believe that.
Take a look at the chart below which shows my model portfolio‘s rolling one-year total return (share price change plus dividends) relative to a FTSE All-Share index tracker:
Let’s say I tell you that my portfolio beat the market by 17% between March 2015 and March 2016 (which it did). Clearly that is a fantastic result and, if sustainable, would put me alongside Buffett as one of the greatest investors on earth.
If my portfolio was a fund then an investor focused on short-term one-year results might have jumped on board in March 2016, won over by its incredible performance.
For such a short-term focused investor, that would have been a bad idea because over the next year, from March 2016 to March 2017, my portfolio underperformed the market by 14%. Clearly that’s a terrible result and if sustained would lead to the portfolio essentially hitting zero in a very short space of time.
If the portfolio was a fund then the short-term focused investor who came on board in March 2016 would probably sell out in March 2017 in disgust.
Common sense suggests that an investor cannot change from being a genius one year to an idiot the next, which means that one-year results are not a very good measure of performance or skill. It’s convenient, but basically useless.
Here are two ways to fix this:
Fix #1: Look at multiple one-year returns over a long period of time
You may just about be able to tell from the chart above that my portfolio’s relative performance is positive more often that negative.
An easier way to measure this is to look at the average rolling one-year return relative to a benchmark.
Using the data from the chart above, which covers about five years, the average one-year relative return is 2.5%.
That means my portfolio beat the All-Share by 2.5% per year, averaged across all of those one-year periods.
This isn’t a perfect performance measure because there is no perfect performance measure, but it’s pretty good I think, and almost infinitely better than just looking at how a portfolio or fund did last year.
Fix #2: Look at returns over periods longer than one year
The other fix is to drop one-year returns completely and use a longer time period. I like to use annualised five year returns, which is a sensible minimum, and I’ll start using ten years as well once my portfolio’s been around that long.
I don’t like the idea of annualised returns over 20 years or more because the results can be skewed by high performance from years ago which hasn’t been achieved more recently (Berkshire Hathaway may be a good example of this).
For me, five and ten year returns are a good compromise between robustness and recency.
Here’s another chart, this time showing the portfolio’s annualised five-year total return relative to the FTSE All-Share:
I think this chart gives a much clearer picture than the one-year returns chart.
Yes, the period covered by the five-year chart is shorter, but that’s because you have to wait a whole five years before getting your first five-year annualised return figures.
Even with such a limited dataset I think the five-year return chart is much more informative than the one-year chart.
The five-year figures are far less volatile, which is what I’d expect to see when measuring something which isn’t volatile (i.e. whether an investor has any skill).
There is still some volatility, but it’s clear just from looking at the chart that the annualised five-year return for the portfolio has been about 3% better than the All-Share’s since March 2016.
My point here isn’t to show you what an amazing investor I am (or not); it’s to show you that looking at last year’s performance in isolation is a bad idea.
So ignore one year returns (unless you’re taking the average from lots of them) and instead focus on five year returns and ten year returns.
Your blood pressure and sanity will thank you for it.