One thing I’ve enjoyed as a parent is teaching our kids how to play games. I’m really excited to eventually teach them more complex board games like Settlers of Catan. But even games like checkers are fun as you watch them learn. As you can imagine, it’s mostly chaos in the early days until they understand the rules.

Playing checkers with a four-year-old isn’t quite the same as playing against my wife. Imagine trying to play any game without understanding and agreeing on the rules. If winning were an arbitrary measure different from the actual rules, it would lead to some pretty strange Checkers’ decisions.

Investors do something similar when evaluating their portfolios.

There are rules for evaluating your investments. Understanding these rules is a valuable skill and can help you be a better long-term investor. If you cannot correctly discern whether parts of your portfolio are doing what they should do, it will lead to investment mistakes.

Most investment evaluation mistakes stem from making your decisions based on returns over the past several years. But more specifically, there are three mistakes investors make when they evaluate their portfolio:

  1. Comparing Apples to Oranges
  2. Evaluating Performance Over a Short Period
  3. Acting Too Soon: Misreading Volatility

Comparing Apples to Oranges

One of the most common problems with managing money is comparing a successful fund in one part of the market to a (seemingly) “less successful” fund in another.

Let’s use a specific example: Pretend that you own a T.Rowe Price U.S. Large-Cap fund.* Let’s pretend you LOVE this fund because it has had a 14% annual return over the past ten years.

That’s pretty incredible. Right?

Let’s assume an advisor shows you a portfolio including some funds that have done worse than your fund–let’s say small-cap & international. You should not invest with that advisor. Right?


There are plenty of reasons why your fund with a 14% return isn’t very good at all. And there are plenty of reasons why you should diversify into other funds that do not have 14% returns over the past ten years.
You are comparing apples to oranges.

What’s Wrong With Your 14% Return?
Your 14% return is not impressive because returns are always relative.

It’s relative to the index the fund is trying to beat. In this case, the S&P 500.

I picked this example because I’ve seen it multiple times in the last several years. The S&P 500 has done about 16% per year for the previous ten years (as of this writing).

2% may not sound like much. However, 2% is a ton in the world of investing. In this real-life example, trailing by 2% with $1 Million over ten years is worth $700,000.

And while it’s unlikely 14% and 16% continue over 30 years (the difference between the two is tens of millions), even a more typical return–say 6% vs. 8%–is worth millions.

Let me be clear: your 14% return, in this real-world example, is markedly bad.

Other Fund Dynamics to Consider
I picked this example because the first large mutual fund company I clicked on happened to have a U.S. large-cap fund that had made 14% per year. As we just addressed–this is a pretty bad return for a U.S. large-cap fund over the last ten years.

Remember my checkers analogy above. If you understand the rules of the investing game, you will ditch this fund despite its 14% return. Additional investigation will show why.

When I evaluate a fund, I don’t ignore the performance numbers. But my focus is on the composition (what is it invested in and why?), the leadership (who manages the fund), the expense ratio, and the turnover rate.
Investment Fees: The Expense Ratio
The expense ratio was over .6% for this fund. Numbers are more helpful in context. So, let’s compare that to the S&P 500 index, which you can purchase with zero expense ratio at some firms and under .05% at many firms.

So, this particular 14% fund charges twelve times the price and is still materially underperforming the benchmark. You are paying a much higher price to get a worse return.

As we’ve discussed on our podcast, we don’t exclusively use index funds in our portfolio. Still, our weighted average expense ratio in our portfolios is around .2%. So, this underperforming fund also charges 3x more than the weighted average expense ratio in our funds.

Your Tax Bill: Turnover Rate
My last investigative point on mutual funds is the turnover rate. This shows how often the manager is buying and selling within 12 months. Our beloved 14% fund had a very high turnover rate. This means if you own this fund in a brokerage account, you receive a much higher tax bill for investing in this fund relative to a fund with a lower turnover rate.

Let’s recap. Your 14% fund:

  • Has underperformed the index by 2% (This is a huge number)
  • Has charged you a substantial fee for this underperformance
  • Has triggered a tax bill you wouldn’t have paid in a lower cost ETF (if you own the fund in a nonretirement brokerage account)

By almost any objective measure, your 14% fund is not good.

Investing in Yesterday?
The next problem in this real example is a principle that every investor needs to take to heart.

You must take returns over the last 3, 5, or 10 years with a grain of salt. Why? Because you don’t get to invest today’s money in the previous 3, 5, or 10 years.

IF you could invest your money in a fund’s previous ten years, investing would be much easier. But you don’t. You have to allocate capital for future returns.

Summarizing the Apples to Oranges Mistake
Back to the example–you have a T.Rowe Price (or insert any fund company) mutual fund that has made 14%/year over the past ten years. Your advisor wants to instead invest in a list of funds–including a few that have made less than 14%.

On the surface, it’s easy to think that your advisor has this beautiful apple (your 14% fund), and he wants to throw it away for other apples (some of which don’t look too appealing). But this isn’t the case.

Your advisor isn’t picking bad apples. He’s picking oranges to go alongside the apples. Oranges might have been worse than apples over the past ten years. But you don’t get to invest in the past ten years. And this could mean oranges are really attractive for the next ten years.

Evaluating your 14%/yr apple to a 6%/yr orange is a nonsensical comparison. Remember the period from 2000-2009. Oranges produced a significantly higher return than apples. Oranges outperforming will likely happen again at some point.

It would help if you instead compared that orange to other oranges. And then ask the question, “Should I include oranges in my portfolio even though they’ve trailed apples recently?”

As I referenced above, “apples” are U.S. large stocks. “Oranges” are everything from international & emerging markets to U.S. small-cap stocks.

Your advisor isn’t throwing away your good apple. Your advisor is saying there is a chance that apples could go bad over the next decade. As a result, you should swap it for a better apple, avoid putting everything in apples, and add oranges and other fruit to the mix.

If you still want to own only apples because they’ve beaten oranges this decade, we have a foundational disagreement about investing. We view markets differently. And we probably wouldn’t work well together. This next point will go further into that idea.

Evaluating Performance Over Short Periods of Time

It’s easy to get caught up in bad results over a short time period.

When I was 11, my dad, brother, and I went to a Kansas State football game in Ames, Iowa. I will never forget badgering my dad before halftime, asking if we could leave early and go home.

I absolutely loved football. That wasn’t the problem. The problem was Iowa State was killing KState 28-7 at halftime. We first got KState season tickets when I was six years old. We had only lost seven regular-season games for the first five years leading up to this game–four to Nebraska (who was in the middle of the second greatest dynasty in CFB history behind Alabama’s current run) and three to Colorado during their glory days.

Getting destroyed by Iowa State was a new experience. I didn’t like it. I wanted it to stop. So I asked my dad if we could go home. He said no.

Kansas State won that game 35-28. Fortunately, my dad did not listen to me, and we saw the entire comeback.

I was laser-focused on a 15-minute stretch where Iowa State scored four touchdowns. But the game wasn’t 15 minutes. It was 60 minutes. The other 45 minutes were drastically different than the short period that made me cry uncle.

We do this same thing with investing. Back to the apples & oranges analogy, we get really frustrated when oranges are struggling. We also tend to get greedy when we see apples doing well–and we think we should put everything in the apple bucket because it will surely continue this way forever.

Just like the football game, history tells us it’s just 15 minutes. And the investing game is a lot longer than that. Let’s take a look.

I wish every investor were required to download this picture when they open a brokerage account. This is an overview of different asset classes and different areas of the market for the past 20 years.

What sticks out as you look at the periodic table of returns?

My takeaway: There isn’t a silver bullet.

I mentioned earlier that you don’t get to invest in the previous 3, 5, or 10 years. You are always allocating capital with uncertainty regarding its future results. As history shows us, there is no way to avoid market crashes (without also taking lackluster returns).

And there is no way to know that one part of the stock market (U.S. large, U.S. small, International, Emerging Markets) will be the best.

Winners don’t always stay winners. This point ties into the section above. Consider this:

U.S. large companies have done uniquely well since 2009. But during the decade prior, they produced a return similar to a checking account at a bank–they struggled substantially.

Small-cap stocks have historically outperformed the S&P 500 for nearly a century! But over the past decade, they’ve noticeably lagged the S&P 500.

Emerging markets haven’t done especially well since 2009. But during the prior decade, they beat everything.

Virtually none of our clients could pick just 1-2 and hope for the best. As a fee-only firm, we are legally obligated to act in our clients’ best interests. There is plenty of evidence that suggests that U.S. and International stock returns are nearly identical over 30 year periods. But our clients don’t get to live in 30 year periods. If we overextend in one part of the global stock market, and that one part struggles for a decade (something we’ve seen multiple times over the past several decades), that has a huge impact on a 65-year-old in retirement and a 50-year-old wanting to retire soon.

Remember, returns are important over 20-30 year periods. But the sequence of returns can be more important.

If the above image taught us that returns are scattered year-to-year, and we can’t guess winners, this next image teaches another vital lesson.

Source: DFA

When you look at a list of funds to invest in, you’re almost always gravitating toward previous performance. Unfortunately, most of the highest-performing funds do not maintain their top performance into the future.

Not only does an excellent stock or fund not always stay excellent–there is reason to believe that winners are going to come back down eventually.

One of the first investment catchphrases we all learn is “buy low. sell high.” It’s still great advice. The tricky part of this advice is that buying low often requires purchasing something that isn’t heralded on front-page news as the sexiest investment.

The popular, easy investment is to buy more Apple, Netflix, Amazon, and Google. And by the way, since we firmly believe that markets are efficient and no one can time the market, we also include those in client portfolios. But we do need to realize that those names demand a price that is several times higher than it was just 5-10 years ago.

By maintaining our position in some of the “oranges,” we are actively following the principles that these two images convey.

Mismanaging Down Periods

I don’t want to communicate that my first two points are easy to follow as an investor. But I do want to say: this last point is noticeably more difficult. The long-term investor must cling to firm convictions (and they better be correct convictions).

Why? Because you’re never going to win all the time as an investor.

Even if “winning” is simply defined as positive upward growth, and you experience that frequently, you’re still going to stare at strategies/funds that outperformed yours from time to time.

I’ll take it a step further. We manage portfolios that, by their very nature, are guaranteed not to produce the highest return every year. Go back and look at the multi-colored periodic table of returns. Something achieves the highest return every year!

If your investment convictions tell you to own some small-cap, large-cap, international, emerging markets, real estate, and bonds, you are guaranteed to trail whichever one of those had the best year.

This is why this last mistake is really difficult to avoid. There is going to come a time when a great portfolio doesn’t do very well. And you’re going to have to make a decision. Do you:

  • Continue with your portfolio strategy despite years of underperformance. OR–
  • Get rid of your portfolio and instead opt for whatever is doing well at the time.

Over the last decade, the best example of this is small-cap and value stocks performing worse than large U.S. tech companies.
For several decades, small-cap stocks have outperformed large-cap stocks. Similarly, value stocks have also outperformed growth stocks. Profitable companies have bested less-profitable companies.

Small, Value, Profitable: The factors that have historically led to higher returns.

We go into this topic further in our investment manifesto episode. There are sound reasons for each factor listed above in an efficient market.

  • If a market is efficient, greater risk can lead to greater performance (small-cap factor).
  • Your purchase price matters in investing. Purchasing a company at a more attractive price than its peers can lead to better performance (value factor)
  • Companies that run better than their peers tend to do better over time (profitability factor).

As a result, it makes sense to tilt your portfolio slightly toward these three factors. But two of the three factors have led to materially worse performance during the 2010s.

Remember when I hammered the mutual fund in the first section because it underperformed by 2% per year?** As the image shows, small-caps and value stocks really struggled last decade.

This is precisely why down periods in your portfolio are hard to manage. A quarter where your portfolio trails another isn’t overly enjoyable. A down year certainly isn’t fun. But neither is a big deal. If a short period causes panic, it’s time to bolster your investment convictions.

But ten years??? Yes. Ten years. And I would strongly argue that it is still in your best interests to slightly tilt toward small companies and value companies despite these ten years.

Let’s remember, when one part of the market struggles for several years (like the S&P 500 from 2000-2009), it’s pretty standard for that undervalued part of the market to do exceptionally well in future years.

In fact, we’re pretty glad that we did maintain these convictions with the portfolios we manage for ourselves and our clients. During the six months starting October 1 of last year, small-cap value increased 70%. In six months!

Warren Buffett

Let’s end this point: if you were looking for concentrated exposure to fill out your large-cap U.S. portion over the past 60 years, has there been anyone better than Warren Buffett?

Pretty incredible results. Remember, Buffett underperformed at different times throughout his career. There were plenty of times where Berkshire investors could have been lured to other investments.

While I am not suggesting you should put your entire U.S. large position in Berkshire Hathaway, I am suggesting enduring principles govern your portfolio over emotion.

A down period is not a reason to change your portfolio. If the underlying philosophical conviction that governs your portfolio is faulty, that would be a reason to change your portfolio. But there will always be times when a great portfolio, great strategy, or great fund underperforms.

*I’m picking a random fund company and have nothing against that particular one. But if the expense ratio and turnover rate are both high, I would likely steer clients away from it.

**How do I reconcile my harsh critique of the 14% mutual fund and go easy here? Because this is still a reasonable strategy with mountains of data and academic research behind it. The 14% mutual fund losing by 2% per year didn’t have that–it just had high fees and poor tax management.