Annual Returns Tell Investors Very Little

Stop the Madness

The earth takes just over 365 days to complete one revolution around the sun, and this amount of time is used to measure countless aspects of our lives. For example, my niece just celebrated her first birthday, my parents have been married for almost fifty years, and I just locked in a 30-year mortgage to buy an apartment in New York City. ¬

Why did mankind choose to use the distance the Earth travels around the sun to be the de facto unit of measurement for time? I don’t know, but at the same time, it really doesn’t matter. Sure, a year is arbitrary, but who’s to say that it’s better or worse than using any other amount of time?

 
Where I do take issue is why the investment industry decided long ago that using a year to gauge investment performance made sense. While there is a clear need for some form of measurement, analyzing annual returns rarely paints an accurate picture for investors because a single year is too short of a time period to gain any relevant information. Why?

 
It’s because the short-term movements in markets are almost always fueled on emotions, and no professional money manager or individual investor on this planet has the ability to consistently predict the emotional reactions in financial markets.
Don’t believe me? Well then let’s walk through a simple case study to prove my point.

Case Study: The Oracle of Omaha

I dedicate a few hours every year to read Berkshire Hathaway’s annual report. Warren Buffet has remained at the helm for over fifty years and is regarded as one of the greatest investors of all time. It’s a great read, and I always feel smarter in some way after finishing the report.

 
The first page of Berkshire’s 2014 annual report compares the 50-year return of his firm’s stock to the S&P 500, and the table below is a brief summary of some staggering numbers:
Berkshire Hathaway                                         Stock S&P 500 with Dividends
Compounded Annual Gain                    21.6%                                                                               9.9%
Overall Gain                                          1,826,163%                                                                            11,196%

 Source: http://www.berkshirehathaway.com/letters/2014ltr.pdf

It’s clear why Buffett is one of the wealthiest individuals in the world. Over the last fifty years, he has outperformed the S&P 500 by over 1 million percentage points, and more than doubled its compounded annual gain!

 
There isn’t a single investor alive who could possibly say anything negative about Buffett’s long-term track record. However, through the lens of annual returns, the story changes dramatically. Buffett has actually under-performed the S&P 500 a third of the years within this time period. Meaning, one out of every three years, he lost to the S&P 500 index. Shorten the investment time horizon even closer, and his track record looks even worse.

 Source: S&P Capital IQ, Global Financial Private Capital analysis

This chart shows that Buffett has trailed the monthly performance of the S&P 500 approximately 45% of the time. Meaning, if he was a hedge fund manager in today’s investment climate, where returns are typically judged on a monthly basis, he could have a tough time raising money.

 
Move in even closer, and you’ll see that he has actually under-performed the S&P 500 more days than he has outperformed!
A year may sound like a long time, but in the grand scheme of things, it is a time period where the most successful investor of all time has under-performed one out of every three attempts. Why?

 
Because Warren Buffett and other highly successful long-term investors know that annual returns are as meaningless as monthly, weekly, and daily returns. They realize that trying to guess the direction of the emotional tide of markets is impossible, so instead they focus on fundamental strategies that often take several years to play out. Simply put, Warren Buffett’s investment career highlights the danger of using annual returns to assess both historical performance and the potential for future returns.

Implications for Investors

I am well aware that no matter how hard I preach about the absurdity of annual returns, the reality is that this industry will never change. Fund managers, marketers, and regulators are just too accustomed to gauging performance over the time it takes the earth to revolve around the sun. This is the bad news.

 
The good news is that investors have a choice. Take off the blinders that this industry has forced upon us all, and focus on the bigger picture. Imagine how many of Buffett’s investors would be kicking themselves right now had they chosen not to invest with him five, ten, or even fifteen years ago on the basis of his short-term performance. The bottom line is that trying to beat the market and/or avoid down periods each year for an extended amount of time is impossible, so don’t even try. Doing so only risks doing more harm than good to a nest egg.