Most people who’ve been trading stocks for a while think that they are excellent stock pickers. They will have all sorts of stories of stocks that they bought and then turned around and made a quick profit. Or maybe they have a stock or two that they’ve held for ten or twenty years where they have a 500% or even 1000% profit. They forget about the losers they’ve had. The stocks that went nowhere.
Really, if you honestly compare your returns to “the market,” many people will find that they would have been better off just investing in a set of mutual funds and following “the market” than they were investing on their own in individual stocks. But how do you tell?
Well, one common way to judge your performance is to compare your returns against those of an appropriate index. For example, if you were buying individual stocks, you might compare your progress against the returns of the S&P500 or S&P100 index. If you were buying small stocks, you might compare your returns against the Russell 2000 index. You could also compare your performance against the return of index funds, such as the Vanguard Total Stock Market Index fund or the Vanguard S&P500 Fund.
Of course, comparing year against year does not always give the clearest picture. For example, here are the returns for the S&P 500 for the last five years, along with the returns for one of my accounts:
Note, to calculate these returns, I just subtract the value at the start of the year from that at the end of the year, then divide the result by the value at the start of the year.
Looking at the returns together, you see that I beat the S&P500 in 2011, 2014, and 2015, but the S&P500 won out in 2012, 2013, and so far in 2016. Should I have just invested in index funds, or is my stock picking actually doing something useful? Well, let’s look at thing s a different way. Let’s say that I invested $1.00 in the S&P500, and also invested $1.00 in my portfolio. Here are the results:
|Year||Return||Value of $1 Invested|
|Start of 2011||$1.00|
|Date||Return||Value of $1 Invested|
|Start of 2011||$1.00|
To calculate these results, I multiplied the value at the end of the previous year by one plus the return for the present year, For example, the 2012 value is just:
($1.05)*(1+0.740) = $1.13.
Now it is clear that I’m beating the S&P500 over the period. If you had invested $1.00 in the S&P500 at the start of 2011, you would have $1.76 now, where by investing in my portfolio over the same period, you would have $1.84. This isn’t much of a difference, but it does show that my efforts at least do mean something. A lot of mutual fund managers do not beat the S&P500. My values also include my brokerage costs and account fees, where the indexes include no fees. It might be more fair to include representative fees in the indexes as well when doing your own comparison.
Another thing to consider is the time period over which you’re comparing. My investing style, which I consider to be the only style worth doing if you’re picking stocks, is long-term investing. I could not tell you which stocks will do better over a year or two, but I can do pretty well at picking stocks that will do well over five or ten years. The fact that I beat the S&P500 in 2011 therefore meant little. It was just good luck. It also didn’t matter that the S&P500 did better than me in 2012. Now that we have five years under our belts, however, we can start to make some real comparisons. Comparisons at ten years would make even more difference, since that will allow my stock picks to really flourish, hopefully, and outpace the market in general.
But, wait a minute, you may say. If you need to wait five or ten years to decide if what you’re doing is working, isn’t that a lot of time lost? After all, you don’t want to go for 20 years, only to discover that you’re a bad stock picker and would have been better off in an S&P500 fund. The answer is that you don’t need to choose one or the other. Instead, put your 401k funds and a good portion of your taxable portfolio into index funds. At the same time, pick a few individual stocks that you think will shine over long periods of time, buy substantial quantities (acquiring 500 to 1000 shares over a period of time). You will then be playing both sides. If you’re a bad stock picker, your index funds will bail you out. If you’re a good stock picker, your individual picks will add to the returns from your index funds, perhaps substantially if you catch something like the next Home Depot or Microsoft. It doesn’t have to be an either-or proposition.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.