When evaluating a mutual fund's performance, I've always focused on year-by-year results. In doing so, I have typically brushed off a bad year here and there, as long as the fund did better than the market (or an appropriate index) in most years.
But managing the Practical Investing portfolio has made me realize the folly of my approach. That's because I've seen firsthand how one especially rotten year can sink long-term results and make it difficult to catch up. Moreover, what looks like a relatively minor difference in annualized returns caused by an occasional bad year adds up to far more than you'd expect when you look at results on a cumulative basis.
The math is pretty simple. And yet, if I had not been forced to compare my own portfolio's returns with a market index, I don't think I would have examined my results closely enough to take stock of the damage.
Dig into the data with me to get a better sense of the problem. My portfolio is with Vanguard's brokerage arm. By using the "balances over time" feature, I calculated year-by-year results for my portfolio, as well as for my small position in Vanguard Total Stock Market ETF (symbol VTI ), the exchange-traded fund that serves as the portfolio's bogey. In all but one year of the portfolio's 5½-year history, its performance has been relatively close to that of the index.
In the first four months of 2017, for example, my portfolio earned 9.7%, compared with 6.8% for the ETF. In 2016, my investments earned 16.7%, and the ETF gained 12.8%. In 2014, I netted 16.0%, versus 12.5% for the index. In 2013, both the index and I gained 33.4%. And in 2012, the year I gradually finished filling out my portfolio, I earned 10.1%; the ETF's return for a comparable period was 13.0%.
The outlier. You may have noticed that I haven't said anything about 2015. Thanks to a few awful picks--as well as my bent toward value stocks, which hurt during a year when large growth companies led the way--my portfolio performed abysmally in 2015. It lost 20.0%, while the overall market essentially broke even. Because of that miserable year, the portfolio's annualized return through April 30, 2017, stood at 10.3%, compared with 13.5% annualized for the benchmark. Not great, but not a disaster, either.
But the impact of my 2015 setback becomes far more dramatic when you look at cumulative results. As of April 30, my portfolio had gained a total of 74.1%--a shocking 31 percentage points less than the ETF.
How did one 20% loss land me 31 percentage points behind? The short answer is compounding. At the end of 2014, my portfolio and the index were neck-and-neck. The actively managed part of my portfolio had earned a cumulative 69.8% and was worth $322,640 (compared with an initial stake of $189,998), while the ETF was up 69.7% and was worth $18,430 (versus an initial investment of $10,863).
But by the end of 2015, the value of my portfolio had shrunk to $258,382. And that meant I needed to earn 25% in 2016 to simply restore the portfolio's end-of-2014 value. Instead, I earned 16.5%. That was not a bad year's work, but my investments were still worth less than they were on December 31, 2014. As for overtaking my benchmark, the chances of that happening anytime soon are remote, even if I can beat it by three to four percentage points per year.
So why bother to buy individual stocks at all? I can't speak for others, but a few things make it worthwhile for me. Investing a small portion of my net worth this way helps keep me abreast of valuations, both on an individual and a market-wide level. That knowledge helps me stay calm when one of my stocks or the overall market stumbles. Besides, I suspect that the humility engendered by comparing my results with the index is good for the soul.