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.
Maynard Paton pointed out that in my 2016 year-end review I said this:
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.
John, All seems like a lot of pain discussing some semantics — There is an old saying in one of the Sherlock Holmes recent episodes — “It is what it is”
Far better to keep looking at the fundamentals of the individual companies, that you happen to do a nice job of, and let the stats take care of themselves.
Now where was I — aggh yes one of my stocks went down 5% today – disaster — who said I wasn’t emotional eh !!
On an older subject — PZC — you wrote an article in Jan 2016 — see I do keep an eye on things in the past.
Well I finaly offloaded PZC today (326.5p) for fear that the upcoming 6 monthy update is going to be received poorly by Mr Market — well it might anyhow — but more importantly I’m working on the basis that £ is strengthening and the crutch from it’s weakness will be kicked away in future reports.
Like your BP sale though it wasn’t a total bloomer as I did receive an 8% gain + 2 years divis in the time and an average of around 6.5% a year — poor but above inflation at least.
How far down your stock screen is it now, I recall it being at around 117?
John Kingham says
No pain for me LR. For some reason or other I actually enjoy crunching numbers in a spreadsheet.
As for PZ Cussons, it just doesn’t rank well on the stock screen I’m afraid (currently sitting at 156). 10yr growth is 3%, ROCE is 10%, both of which are mediocre. The yield is low at 2.5% so I see nothing to get excited about. If I owned it I’d sell it too.
Hippidus Hoppidus says
This is my last message John. Seeing my last 2 comments not make the site tells me you are not open to hard questions or criticism. Good luck to you mate.
John Kingham says
Hi HH, I just found one of your comments in the spam folder, so apologies for that. I’ll enter a reply now. And don’t worry, I accept sensible criticism with open arms.
HH – I would imagine John is correct, your messages have just gone astray.
Rest assured, I write all manner of critical nonesense and he hasn’t blocked me yet :).
I would take it a step further … Past Performance Is Not Indicative Of Future Results. Looking at 1 year investment performance is speculative investing.
John Kingham says
I definitely agree with this. The problem is that we need some way of choosing one investment over another, so we have to assume at some level that past performance IS a guide to future performance. Even if it’s as simple as choosing to investing in equities rather than cash because equities have historically produced far better returns than cash. We’re still relying on the past, and that has to be the case since the future is unknowable.
I guess we’re talking more about how good a guide something is. In equities, last year’s return is a terrible guide to long-term returns, but 5yr returns and 10yr returns (and longer) have historically been better guides.
Short term outperformance is essentially meaningless as there is no way of knowing if it is purely due to chance.
The reasonable test for investor performance is to measure across a complete market cycle – i.e including a serious bear market. A bear tests out all the key aspects of an investing skill and psychological resilience that are the key in long term investment outperformance. Most investors do well in a bull market – by definition- but a large number get killed or get shaken out during periods of extreme pessimism and it is one of the things you can only know if you experience it first hand – something about watching your portfolio bleed value for months or years..
We have not had this since 2009 ( apart from a couple of bearish 6 month periods in 2011 and 2015/16) so anyone who has been investing only in this period will not really know how they will behave as an investor when a long, bearish grind downwards hits.
My personal benchmark is more than 8% across all conditions. i am lucky to have managed an 11% annual return since 2001 and that is more than adequate regardless of what the market has done.
For what its worth, the 3 year figures are 18% per annum and 15% per annum over 6 years but I put this down to being in a bull market and more down to luck than skill. I expect the figures to decrease to the long term average that includes a serious bear market.
John Kingham says
Hi Lemsip, excellent comment and I 100% agree.
Although it’s nice that we haven’t had a bear market for almost a decade, it’s also annoying because I haven’t been able to measure my performance as a “defensive value” investor through a full cycle yet. I only switched from deep value to defensive value in 2010/2011, so although that’s seven years now it still hasn’t included a full cycle.
Fortunately (or not) I have been investing since 1995, so I’ve seen two major bear markets with declines of about 50% in both. The first one (2001-2003) I sold out at the bottom, shaken out of the market by fear. That was a good but expensive lesson for a newbie passive investor. Then I panic-sold my oil-related funds in 2009 for the same reason, after which I decided to focus 100% on individual stocks which I can analyse in much more detail and feel much more comfortable with. When the next bear market rolls around I’m completely confident that I won’t panic sell anything, largely because I’ve already learned that lesson twice and a third lesson should not be necessary!