5 Ways to measure investment performance

In this post, I focus on five investment performance metrics which are long-term in nature and which could help you avoid the perils of a short-term mindset.

Why you should be a long-term investor

Most investors know you shouldn’t invest in the stock market if you’re likely to need the money back within five years.

That’s because in the short-term (periods of less than five years) the stock market is like a casino. Your short-term returns are driven primarily by the random ups and downs of the market and you’re about as likely to lose money as you are to gain it.

But in the long term, thanks to inflation and real economic growth, companies tend to get bigger and the stock market goes up.

The market will still follow an almost random walk, but in the long run, the random ups and downs cancel each other out and you are left with something close to the underlying economic growth.

This is very similar to property investing. If you buy a house today and sell it next month or even next year there’s a very good chance you’ll lose money. But if you buy today and sell in a decade, the odds of a successful outcome are immeasurably higher.

So sensible investing is long-term investing.

But for most people, it’s all too easy to focus on the excitement and fear of daily share price fluctuations rather than the infrequent drip of company annual reports.

What we humans need is something to focus our attention on our important long-term investment goals and away from irrelevant short-term volatility.

Use long-term performance metrics

One solution is to use performance metrics which are almost exclusively focused on the long term.

For example, the UK Value Investor model portfolio has three goals and five core performance metrics:

• Goal 1: Above-average growth
  • Metric 1: Beat the FTSE All-Share over five years
  • Metric 2: Grow from £50k to £1m within 30 years (requires an annual return of at least 10% per year)
• Goal 2: Above-average income
  • Metric 3: Have a higher dividend yield than the FTSE All-Share
• Goal 3: Below-average risk
  • Metric 4: Suffer a smaller maximum decline than the All-Share over five years
  • Metric 5: Produce a positive capital gain over five years

With the exception of dividend yield, all of those investment performance metrics are focused on the longer-term, five-year-plus time horizon.

As a result, I don’t track the portfolio’s performance over the last month, quarter or even the last year. Such short-time horizons should be completely irrelevant to the long-term investor.

Let’s have a look at some of those performance metrics in detail so you can get an idea of how they work in the real world.

#1: Beat the FTSE All-Share over five years

Beating the FTSE All-Share over five years means beating it on a total return (i.e. capital gains plus dividend income) basis.

For the traditionalists, here’s the standard “value over time” view of the model portfolio versus its arch enemy, the Vanguard FTSE All-Share tracker:

As you can see, the model portfolio has beaten the market. Hooray for me.

The problem with this chart and this way of looking at performance is that it highlights all the irrelevant share price noise.

For example, you might look at the 2014-2016 period when the All-Share’s price declined and say:

“Oh dear, look at how risky that is. If I’d bought in 2014 and sold in 2016 I would have lost money.”

That would be true, but it would also be a really bad way to think about investing.

That would be like buying a house for £500k and then for no good reason selling it to Dave down the pub a year later for £250k, just because Dave tells you that’s what it’s worth.

Yes you would have lost money on the house, but that doesn’t mean the house was a risky investment. It just means you made a very bad sell decision.

So the daily, weekly, monthly and even yearly ups and downs in price (not intrinsic value, which is a very different thing) are a distraction and should, for the most part, be ignored.

Of course, in the real world that’s going to be impossible. But we can at least focus on the long-term more and the short-term less.

How so?

Take a look at this chart. It shows the same investments, but this time it just their total returns over five years:

For example, the All-Share’s five-year total return to May 2016 (i.e. from May 2011) was about 25% and its five-year total return to July 2018 (i.e. from July 2013) was about 50%.

As you can see, the FTSE All-Share’s five-year return over the last few years has always been positive (because we’ve been in a bull market since 2009), with an average five-year return of 52%.

The model portfolio’s five-year total return was always slightly higher, with an average five-year return of 77%.

For most people, if you asked them if they’d like to invest and get between 52% and 77% over five years, they’d bite your hand off.

But most people don’t think of it like that.

Instead, they think about the fact that the market went down between 2014 and 2016 and they think about the risk of losing money.

And that fear stops them from getting a 50% or higher return over five years.

And while your five-year return will vary over time, it won’t vary anything like as much as your returns over one year, and that means it should be less stressful to periodically review.

So if you track your portfolio’s performance I suggest this:

• Start tracking investment returns over five years
• Make that your primary measure of returns
• If you’re brave, stop tracking returns over one year or less

#2: Grow from £50k to £1m within 30 years

Five-year goals are nice, but I think it’s important to have very long-term investment goals as well.

For example:

• Accumulation phase: Build a portfolio of shares which can generate a £20,000 dividend income.
• Income phase: Grow your dividend income ahead of inflation for the rest of your life.

Either way, a multi-decade goal can be useful if it inspires you to save harder or invest wiser.

For the model portfolio, the long-term goal is to grow from £50,000 to £1 million within thirty years (with a start date of March 2011).

It’s still early days, but here’s the progress so far:

What I like about the Millionometer is that each milestone is double the previous one.

This makes sense because investing is all about exponential returns, not linear returns.

So if your rate of return is the same, it will take you the same amount of time to go from £400k to £800k as it took you to go from £50k to £100k, despite the increase being eight-times larger in Sterling terms.

That is the magic of compound interest (as shown by Monevator’s handy compound interest calculator).

So after seven years the model portfolio has more or less doubled in value. At that rate it’ll hit £200k in 2025, £400k in 2032 and £800k in 2039.

That will be just before its 30th anniversary in 2041, so the portfolio is more or less on target to reach it’s very long-term million pound goal.

Some key takeaways:

• A five-year time horizon is a good minimum, but your real focus should probably be on getting good returns over the next few decades
• Have a very long-term goal that inspires you to save hard and invest wisely (a phrase borrowed from the excellent Retirement Investing Today blog)
• Don’t bet the farm! As management guru Jim Collins once said, “if you get four tails in a row and you know that eventually you’re going to get heads again, it doesn’t matter if you get killed on tail number four.”

#3: Have a higher dividend yield than the FTSE All-Share

Okay, this one’s a bit simpler.

The model portfolio is designed to be of interest to both growth and income-focused investors, so it needs to always have a higher dividend yield than the FTSE All-Share.

This is obviously a very common metric and is easy to measure, so here’s a chart showing dividend yield since 2013 (the portfolio started in 2011 but was only partially invested for the first year or so, and dividends from that early period are unrepresentative):

I think there are two interesting features of this chart:

1. The FTSE All-Share’s yield is still above 3%, despite the long bull market we’ve been in
2. The gap between the model portfolio’s yield and the All-Share’s yield has shrunk, a lot

On the second point, the underlying investment strategy (Defensive Value Investing) was more focused on value than quality in the early days. As a result it selected more high yield investments.

Over the years I’ve updated the strategy and it’s now more balanced between value companies and quality companies, and of course the quality companies tend to cost more and have lower dividend yields (because of expectations of higher dividend growth).

If the model portfolio’s yield does drop below the All-Share’s yield then I’ll have make some adjustments.

That will mean offloading some of the more expensive lower yield holdings and replacing them with higher yield stocks.

But if I do that it will still be done slowly and steadily, at my usual pace of one buy or sell trade each month.

To finish off the topic of yield, here’s what the actual dividend payments look like for the model portfolio and its benchmark:

#4: Suffer a smaller maximum decline than the All-Share over five years

Although most of the time you should ignore share price volatility, in the real world that’s likely to be impossible (when the market declines by 50% it’s pretty hard to ignore).

One way to cheer yourself up when the market’s crashing is to be able to say:

“My portfolio may be down, but not as much as everyone else’s!”

In this case “everyone else” is the market and all of the passive index trackers that follow it.

To be honest that isn’t very comforting when you’re down by 25%, but along with a long-term focus (“I’m down 25% this year but up 50% over the last five years, and that’s what matters”) it could be enough to stop you panic selling at precisely the wrong moment.

This is also easy to track.

All you need to do is note your portfolio value each month (or whatever frequency suits) and keep a note of its all-time high value. After that it’s easy to calculate where you are today relative to that all-time high.

Do the same for the FTSE All-Share and hey presto, you can compare the size of your decline.

For example, over the last five years:

• The model portfolio’s biggest decline from a previous high was 4.4%. That isn’t even a “correction”, to use the stock market lingo.
• The FTSE All-Share’s biggest decline was 11.4% between 2014 and 2016, which would be classified as a small “correction”.

Neither of those declines is particularly scary, but this metric will definitely come in handy when the declines are bigger (although still temporary when you take a long-term view).

I don’t have a chart of maximum declines as it doesn’t change very much. Instead, here’s a chart showing all declines for the model portfolio and FTSE All-Share from previous highs:

My tip for coping with market declines:

• If you don’t like to see your portfolio fall in value, try to invest in a diverse portfolio of quality companies at attractive prices
• Compare your declines against the market and celebrate if your declines are smaller
• Think about your positive returns over the last five years and not just your negative returns of the short-term past

#5: Produce a positive capital gain over five years

The idea behind this metric is that most people hate the idea of losing money in the stock market. They think if a share’s price falls below their purchase price they’ve “lost money”.

And if their shares fall a lot, many of them will panic sell to avoid further “pain”.

This is a really bad way to invest. Let’s go back to the example of your house and Dave down the pub:

If you purchased your house for £500k and the next day Dave down the pub says he’ll buy it from you for £250k, have you lost any money?

The answer is obviously no, as long as you ignore Dave and his ridiculous offer.

And in most cases investors are free to ignore the market when it marks down a company’s shares.

Unfortunately though, most investors are simply unable to ignore the market’s opinion.

That’s where this goal of producing positive five-year returns comes in.

In effect, aiming at always-positive five-year returns means you’ll be able to say:

“Okay, my portfolio was worth £100k last week and this week it’s down to £80k. I could sell now to avoid further losses, but I’m pretty sure that in five years it will be higher than £100k. And in all likelihood it will be much higher. So this decline is a temporary blip and is nothing to worry about.”

Obviously you’d need to back up those words with an investment strategy that is likely to deliver the goods, but I think it’s a powerful mindset.

I’m sure it won’t stop people panic selling at the bottom of bear markets, but it’s a step in the right direction.

As for how the model portfolio has done relative to this goal, its five year returns have been consistently positive thanks to the post-2009 bull market.

The real test will of course come when we enter the next major bear market.

So, if you have a tendency to panic when the market or your investments suffer price falls, try this:

• Focus on where your portfolio will be in five years
• Think about the positive returns you expect to get over the next five years
• Think about how much your portfolio has grown over the last five years
• Remember that the share price of each company is simply someone else’s opinion
• Stick with an investment strategy that focuses on above average companies at below average prices

Congratulations for making it to the end of this Very Long Blog Post. If you have any unusual performance metrics of your own then please share them in the comments below.