Don’t Get Rich Any Slower Than You Have To

This is one of those boring articles about investing that is actually very important. To liven things up, J.D. has illustrated this article with photos of one of his cats.

It's quiz time, folks. See if you can answer any or all of the following questions:

  • Do you know what your entire portfolio earned over the past year?
  • What's your best-performing investment? Your worst?
  • If you invest in mutual funds, do you know how many of your funds are beating their benchmarks?
  • Would you have been better off investing in a collection of index funds?

Did you have answers to all those questions? If you did, how confident are you that your responses are accurate?

My experience talking to friends, family, and, yes, even Motley Fool colleagues is that most investors have only a vague idea of how their portfolios have performed. I've found confirmation in a survey of German investors conducted by professors Markus Glaser and Martin Weber, who also were able to analyze the investors' online brokerage accounts. They found that the returns were an average of 11.5 percentage points worse than the investors had thought; only 5% of survey respondents reported negative returns, but in reality 25% had losing portfolios.

Simon Loves Kris' Lap
Ignorance is not bliss

Ignorance is NOT bliss
If your definition of “get rich slowly” includes putting at least some of your savings somewhere besides the bank, then chances are you spend time and money trying to identify better-than-average investments. You might do a lot of research in an attempt to pick outstanding stocks. Maybe you scrutinize data to identify exceptional mutual funds. Perhaps you regularly adjust your asset allocation to maximize returns. Or maybe some of your money is managed by an investment advisor. But unless you keep tabs on your returns and compare them to the proper benchmarks, you won't know whether any of these efforts are paying off — or whether you'd have tens of thousands more dollars if you'd only done something else.

No, you shouldn't look at your investments each and every day — that way lies madness — but once a year, you do need to evaluate the returns of your investments and the skills of the people who are picking them, be they mutual fund managers, financial advisors, or that good-looking investor in the mirror.

Convinced? Great. As with most worthwhile pursuits, though, the process isn't a simple one. You really have two questions to answer:

  1. Do you have the best individual investments? Is your international stock fund the right one for you? Has the stock you purchased two years ago lived up to your expectations?
  2. Do you have the right mix of investments? How has your stew of cash, bonds, and stocks fared over the past few years? Are you — or your advisor — making overall asset allocation decisions that compare favorably to what others are doing?

The first place to look for answers is your account statements, especially since you'll begin receiving year-end statements soon. Those will display your returns, which is a start. But determining whether those returns are good, relative to similar investments and what you could have earned elsewhere, will require another step.

Simon Climbing a Ladder
To climb the ladder of investment success, you have to be vigilant.

Evaluating performance
A quick and easy way to evaluate a single investment more fully is to enter its ticker on Morningstar.com and click on “Performance” in the gray area under the investment name and ticker. You'll find year-by-year and annualized longer-term return information, as well as comparisons to similar investments.

Here's what to look for, depending on the type of investment:

Stocks
Morningstar provides total return numbers (which includes changes in the stock price as well as dividends) and compares them to the returns of the company's overall industry. It also compares the stock's performance to the S&P 500, which is not the appropriate benchmark in most cases, since it's an index of mostly large U.S. stocks. Rather, small-cap stocks should be compared to a small-cap index, emerging-market stocks to an emerging-markets index, and so on. You can find a clue to the stock's appropriate benchmark on its main “Quote” page on Morningstar by clicking on “Company Profile.”

Once you have a handle on the kind of stock you own, you'll need to compare its performance to a similar index or index fund over a period that approximates your holding period. It may not be meaningful if a few of your stocks are underperforming their indexes; if your investment thesis remains solid, they may just be even better bargains now than when you bought them. However, if over a three- to five-year period your similar stocks, as a group, are underperforming a relevant index fund, then it might be time to re-evaluate your stock-picking process (and prowess).

Mutual Funds
Besides providing total return information, Morningstar ranks the performance of a mutual fund compared with other funds with similar investment objectives. Look in the “% Rank in Category” row on the “Performance” page, and choose a time frame that is long enough to be meaningful — at least five years, preferably 10. The lower the number, the better. For example, you'll find a 6 in the “5-Year” column for the Dodge & Cox International Fund (DODFX), which means its performance ranks among the top 6% of funds that invest in large-cap value international stocks.

Over the long term, approximately two-thirds of actively-managed funds underperform their indexes. If your actively-managed fund doesn't score a 33 or higher in the “% Rank” row over a five-year period, and especially over a 10-year period, it's among that less-than-illustrious group, which means it's time to reconsider the fund.

Mind Games
Guard against under-performing funds.

If you're holding a fund outside your tax-advantaged retirement accounts (like a Roth IRA or a 401(k)), the next step is to compare the fund's after-tax returns to other funds in its category. To do this, enter the fund's ticker on Morningstar.com, then click on “Tax” in the gray area under the fund's name and ticker. There, you'll see how much of the fund's return was handed over to Uncle Sam, assuming the highest individual tax bracket of 35%. The average equity mutual fund has a “tax-cost ratio” between 1 and 1.2, which means an investor in that average fund loses 1.0% to 1.2% of return to taxes every year.

Given that the large majority of investors are not in the top tax bracket, the amount lost to taxes is not quite so bad for most people. But it's still something to monitor for the funds you hold outside IRAs and 401(k)s — especially if the fund is barely beating a comparable index fund, since index funds' tax-cost ratios tend to be just one-fourth to one-half those of similarly invested actively managed funds.

Exchange-Traded Funds (ETFs)
In the 1990s and early 2000s, an ETF was just an index fund that traded like a stock. Not anymore. Now, many ETFs are investment strategies disguised as index funds. There are a ton of them, and not all of them perform the same. For example, there are 11 U.S. small-cap blend ETFs (“blend” indicates that the fund is not strongly value- or growth-oriented), according to Morningstar's ETF Performance tool. Their annualized returns over the past three years range from -0.5% a year to 11.8% a year. Obviously, you want to make sure your ETFs are among the better performers.

Given their reputation for tax efficiency, ETFs are often purchased outside of tax-advantaged retirement accounts. But their tax efficiency varies, so if you hold ETFs outside an IRA or 401(k), make sure you're keeping as large a percentage of your returns as possible by checking your funds' tax-cost ratio on the Morningstar “Tax” page.

Simon in the Workshop
Keep a watch on how your overall portfolio is performing. Is it meeting your goals?

Tasting the Whole Enchilada
Evaluating an entire portfolio is trickier, since investors tend to have accounts scattered about — perhaps a 401(k) here and an IRA over there — and choosing the right benchmark isn't always clear. If all your investments are with one firm, then you should have a good idea of how your overall portfolio has performed. Otherwise, you need to use financial tools such as Quicken, Wikinvest, or online portfolio trackers at Morningstar.com, Yahoo Finance, or Google Finance. However, this is crucial: Make sure you're measuring of the performance of your investments, and not counting cash contributions to your account as investment growth (as the Beardstown Ladies did in the 1990s).

Once you know how well your investment performed as a group, what do you compare it to? My suggestion is a similarly allocated target retirement mutual fund from fund company Vanguard. These mutual funds provide instant asset allocation — a prudent mix of cash, bonds, and stocks (both U.S. and international) based on a general retirement date. As that date approaches, the allocation becomes gradually more conservative — which is what most investors should do. Since the fund is from Vanguard, the money is invested in a collection of low-cost index funds. If your investments, as a group, are losing to a target retirement account, it might be time to invest in one instead.

Is anyone still reading?
If you're still with me, I commend you. This is pretty boring, technical stuff. But it's crucial. Too many investors spend their lives choosing below-average investments, often paying financial advisors and mutual fund managers for below-average returns. The result: These investors reach their sixties with tens of thousands of dollars — maybe hundreds of thousands of dollars — less than what they could have had. Don't be another financial-services sucker. Keep your advisor, fund manager, and/or yourself accountable.

More about...Investing, Retirement

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LifeAndMyFinances
LifeAndMyFinances
9 years ago

Good tips about MorningStar. They are a good tool to use when analyzing your portfolio.

I have to admit, even the cats didn’t keep my attention on this article… I skimmed down to the bottom and read the title, “Are you still reading this?”, and I had to answer “no…”. I’ll have to tackle this article in peices throughout the day. 🙂

Annemarie
Annemarie
9 years ago

Excellent post. I now know what I’ll be doing today.

Rob Bennett
Rob Bennett
9 years ago

No, you shouldn’t look at your investments each and every day – that way lies madness – but once a year, you do need to evaluate the returns of your investments and the skills of the people who are picking them The same madness that applies in the former scenario applies in the latter. A good investment strategy will not necessarily perform well in one year and a bad investment strategy will not necessarily perform well in one year. What is being advocated here is a slightly more long-term strategy than the approach described as “pure madness,” but not much… Read more »

retirebyforty
retirebyforty
9 years ago

Huge post! I keep track of my investments in an excel spreadsheet and I do know how my total portfolio did in 2010. Other than that, I can’t answer the rest of the questions with any confidence.
Well, I know Netflix was the best % gainer. Most of my investments are in mutual funds and I need to check up on them with Morningstar like you recommended and make sure they are at least at the top tier. I do have DODFX. 🙂

Chickybeth
Chickybeth
9 years ago

Thank you so much for this timely post. I get Money magazine and they do a year-end review of most fund, ETFs, etc. In their analysis for this year, the ETF funds I had picked to go with long term didn’t so well compared to their peers and this made me nervous that I should switch to a different set of funds. Really though, I just had no idea how to know if I was in a bad fund or not, so I really appreciate this post. According to Morningstar, the ones I picked over a 10 year period got… Read more »

Jim Fauntleroy
Jim Fauntleroy
9 years ago

I disagree. Does it matter if the S&P goes down 10% and your portfolio goes down 5%? Congratulations, you beat the S&P. What matters is are you going to have enough money to meet your goals, like retirement and education for your kids. What I care about is that all of my investments have positive returns and that I minimize risk. I rank my investments and one that seriously under performs I try and trade up. But if a mutual fund has positive returns and is at least in the middle of the pack for the asset class, I don’t… Read more »

Crystal@BFS
9 years ago

I couldn’t agree more. Since I did just write a post for the end of the month about our stock portfolio, I know how it’s doing (up 4% overall). BUT, before I wrote that post, I had no clue.

I barely glance at our Scottrade account and have mentally made it my husband’s thing. Now, I can tell you how my 401(k) and Roth IRA are doing at any given point (up 18% overall). I watch my babies and let my husband watch his, lol.

Anyway, thanks for the reminder!

Nicole
Nicole
9 years ago

I like the motley fool stuff that says: 1. You’re best off using index funds 2. You *sure* you want to use something other than index funds? 3. No really, index funds. Compare them by their expenses. Here’s some heuristics given your age about what kinds to get. 4. Ok, if you’re not into index funds, then you can look at the rest of the site, but don’t say we didn’t warn you. 5. Btw, re-balance once a year. That way people can skip #4 entirely (which I kind of did in this article. Who cares about comparing mutual funds–… Read more »

Kevin
Kevin
9 years ago

I’m conflicted about this post. I found myself agreeing with 95% of the content, but every now and then, I’d catch Robert committing a classic fallacy (eg., equating past returns with future performance) that jolted me out of agreement and coloured the whole thing as bunk. I’ll admit that the information about how to use Morningstar was very useful. But the recommendations to “only invest in winning mutual funds” is a classic mistake that defies basic logic. Who in their right mind would invest in losing mutual funds? EVERYONE thinks their mutual funds are winners when they’re buying them –… Read more »

Everyday Tips
Everyday Tips
9 years ago

I haven’t even gotten all my statements, but I do know how my investments did through 3rd quarter. I do not stress too much if I am over/under performing the market in any one area because I am pretty diversified amongst mutual fund classes. (And I have some index funds.) I try to invest in funds that have a low expense ratio and good past performance. Outside of that, I don’t have a crystal ball so I don’t do a lot of switching. However, as I get closer to retirement, I will be moving some of my stocks into safer… Read more »

dotCOMreport
dotCOMreport
9 years ago

I agree in theory with the case for checking out my funds once a year but truthfully? I would still need the help of a professional to know what is going on.

Soledad
Soledad
9 years ago

Nice article. I just had this sink in recently looking at tax documents.

I LOVE the cats!

Luke
Luke
9 years ago

I actually knew most of those answers – must be checking too often! Solid article, but I can appreciate why J.D. tried to jazz it up with cats. On a related point, J.D. – please don’t release a series of awful posters with PF slogans and and cats (visualises cat sitting on a jar of money with ‘nobody cares about your money more than you’ etc. 😀 J.D.’s note: Luke, you have opened a can of worms. Or a can of cats, actually. I love this idea, and you will get full credit when I eventually unleash my cat-themed personal-finance… Read more »

schmei
schmei
9 years ago

I hope I’m not the only one who scrolled through to check out all the kitty pictures first…

I also think this may just apply to me later in my life, both because I’ll be closer to retirement and because I’ll be in the Third Phase of personal finance. Right now we’re still focusing on the debt payoff/savings buildup, so the fact that I’m investing at all (with a nice employer match) is honestly good enough for me. I do know roughly how I did in 2010, and I know the number increased, so I’m happy.

Chris
Chris
9 years ago

I’m confused by the “% Rank by Category”. One of the mutual funds my advisor has selected is CWGIX. I can see the row, is it supposed to calculate this average for me over a 5 or 10 year period, or do I average it out myself?

Julia
Julia
9 years ago

The cat photos totally helped me slog through – I figure if they can follow Robert’s advice, so can I 😉 An annual review that trots you through a tedious analysis of your investments MAY not help you fine tune the situation, but it definitely CAN prevent a disaster that plays out over say, one to three years. In my workplace I have witnessed some epic carelessness that resulted in huge, totally avoidable losses. Over-reliance on paid professionals & not reading the statements were the common threads. And I say this as the English degree-assistant to a crowd of science… Read more »

Amy
Amy
9 years ago

I haven’t finished slogging through the article, but I have looked at all the pictures (sad, no?).
JD if you ever tackle writing a book about money management principles for children, I think you can illustrate it beautifully with pictures of your cats.

Patrick
Patrick
9 years ago

Dude those cats are lame, and they distract from your article.

cc
cc
9 years ago

thank you for the reminder. i keep meaning to “go over” my portfolio, but i’ve been putting it off for, well, 12 days now.
the kitty photos helped. i will soon climb the ladder of wise investments myself.

cc
cc
9 years ago

oh man, question. i know everyone dumps on mutual funds, so i am happily anonymously saying i own a ton of them. the catch? they’re all no-load, no-fee, from a happy hippie company that spreads warmth and sunshine (usaa). i haven’t seen any fees kick in, but am i fooling myself that it’s a good deal? are there super hidden fees that are killing me and i don’t even know it? should i dump all my mutual funds for indexes? (not likely!)

Robert Brokamp
Robert Brokamp
9 years ago

@Rob – Good point. Investment strategies should be evaluated over longer timeframes than one year. However, once a year you should see how your funds/strategies have done over the previous three to five to 10 years. For those advocating index funds: I’m a fan (review my past posts). However, 1) most people invest through their work plans – e.g., a 401(k) – and most work plans don’t have more than a S&P 500 index fund, which might be fine for your U.S. large-cap allocation, but you still should be picking a bond fund, an international stock fund, etc. Also, just… Read more »

Wes
Wes
9 years ago

I’m curious – does anyone have a good way of tracking returns that doesn’t count cash contributions (as Robert notes) but does accurately account for returns of incremental investments, dividends, coupon payments, vesting, etc.? I ask because I’m in venture capital, spending every day doing financial analysis, but have yet to come up with a way to accurately analyze my returns on my dollar-cost-averaging strategy. Obviously it’s more complicated than (EOY balance – (BOY balance + contributions))/(BOY balance + contributions) = return (note that because this formula treats contributions across the year as invested at the beginning of the year,… Read more »

David C
David C
9 years ago

I would do really well until I came across a picture of the cat. Then it was “Aaaahhh, a kitty cat.” Then I lost my train of thought…

Rosa Rugosa
Rosa Rugosa
9 years ago

The cat photos ROCK!

cerb
cerb
9 years ago

Good article, especially with the input of Kevin #9 above, to provide balance.

Love the cats 🙂

Kevin
Kevin
9 years ago

@Robert:

“A minority of funds DO outperform relevant index funds.”

That’s why I included the clause “on a long enough timeline.” Eventually, every mutual fund lags its index on average, purely because of expenses. Even Peter Lynch’s vaunted Magellan fund eventually posted some losing years. I simply do not believe that anyone has the ability to consistenly pick stocks that will beat the index, year after year, indefinitely. Eventually, they all guess wrong.

Joan
Joan
9 years ago

Yep. Read to the end to see more cats. But I’m glad I did. We’re JUST beginning to work on investing – taking more control of our 401(k)s and state tuition savings plan for our daughter. This is good stuff to keep in mind as we move forward!

Sonja
Sonja
9 years ago

I must be the only one who had problems using the Morningstar site as noted. I didn’t see all the areas in the “gray area.” Is that only accessible to Morningstar subscribers? A handy visual would have been a screen shot with callouts (arrows, circles) to help direct people to better use that site. Otherwise, an excellent article. I have been thinking about this a lot because I am don’t think our advisor is doing any better than I could at the moment if I’d just dedicate the time. I think the only benefit he’s providing is portfolio balance… Thanks… Read more »

Glenn Dixon
Glenn Dixon
9 years ago

Remember when the Motley Fool was all about why mutual funds were generally a bad investment? Oh yeah, that was before they started their own mutual fund :o) Here are some sobering numbers for those of you contemplating investing in general: S&P 500 – March 12, 1999 — 1294.59 S&P 500 – January 12, 2011 — 1283.20 Quick – what is that rate of return? Oh, and don’t forget to adjust for inflation… ;o) J.D.’s note: Glenn, those numbers don’t include dividends, right? Plus, they’re anomalous, right? I mean, nobody denies that the overall stock market return from the past… Read more »

Nicole
Nicole
9 years ago

@Robert 5% of the time weird stuff happens with a 95% confidence interval. So what? That is irrelevant when it comes to mutual funds. Just based on averages 50% of funds will beat the market if mutual fund managers pick stocks randomly. The expenses that a mutual fund manager adds (combined with the emotional investing mistakes even a manager makes) make that less than 50%, which has also been shown empirically. And there’s zero way of knowing which will have randomly hit the jackpot that year. There is no trick to figuring out which ones will out perform. Mutual funds… Read more »

Jeff
Jeff
9 years ago

I made it through the entire article without falling asleep. Ya-hoo!

I always compare my annual returns with against “lazy portfolios” returns. While this is not an exact science, it’s good practice and takes 15 minutes to do.

http://www.marketwatch.com/lazyportfolio

JeffB
JeffB
9 years ago

Wes – if you use a 50% weight on the contributions in the denominator, it will give you a pretty good estimate for dollar cost averaging. This is how retirement plans used to determine earnings allocations back in the days when they were only valued quarterly or annually.

Kent @ The Financial Philosopher
Kent @ The Financial Philosopher
9 years ago

The greatest control determinants of overall portfolio performance are expenses and asset allocation, not investment selection.

Highlighting investment performance and investment selection has the tendency of perpetuating poor investor behavior (i.e. chasing performance).

“Slow down and the thing you are chasing will come around and catch you.” ~ Zen saying

Crystal
Crystal
9 years ago

I don’t see how being overly concerned with this would help. I have CD’s, 401K, and a Roth IRA. Knowing that if I had done A instead of B I’d have 10K more would upset me to no end-no matter what my final tally was I’d always feel like I’m 10K short. Just keep doing what you are doing-most people cannot even scrape up enough to save ANYTHING so you’re ahead of most

Ann
Ann
9 years ago

GREAT Cat pictures! Now I’m going to have to read this to see what it is all about!

Tyler Karaszewski
Tyler Karaszewski
9 years ago

I dont get how the same people who like to say “past performance is no indication of future returns” will turn around and in the next breath say “so pick index funds, because the past performance of the US stock market is ~10% growth each year” Why do index funds get special case status in this equation? The continued performance of these funds basically depends on the continual exponential growth of the American economy, and when you get right down to it, no exponential growth curve that requires actual, physical resources (people, energy, cars, houses, all the things the economy… Read more »

Glenn Dixon
Glenn Dixon
9 years ago

JD – no, I wasn’t including dividends. I think everyone is aware of the LONG-term track record of the stock market. But the question is whether or not the current malaise is a plateau or a long-term sideways move. The return may be 10% but that misses two points: 1 – does that 10% include the last decade? 2 – if the average return is 10%, why is it that the average investor typically underperforms the market by up to 15%? (see Barber and Odeon, summarized here: http://wallstcheatsheet.com/breaking-news/economy/how-do-individual-investors-manage-to-lose-money-in-the-stock-market.html) ” Another interesting finding of this study was that an average individual… Read more »

Bella
Bella
9 years ago

Is there anyone else who thinks. That’s why I pay someone to do this for me? Im never going to get rich in thestock market. Almost all my investments are tax advantaged. 401k ira etc. I figure that being in top tax bracket means that I just need to not lose relative to my peers and ill be making good returns. I find monitoring the market about as interesting as cleaning my toilets. Id much rather find other ways of investing like property or vintage autos or starting my own business.

Heather
Heather
9 years ago

I’m not dumb. But this post makes me feel a little dumb. I haven’t been more interactive with investments than throwing money into a hole, then peeking in once in a while to see if anything is happening. That’s probably bad, right?

Also, I didn’t know kitties can climb ladders. This changes everything.

Petunia
Petunia
9 years ago

I don’t bother to compare my funds’ performance with the appropriate benchmark indexes. There is no reason to do so, since I invest in the lowest cost index vehicles I can find.

Kevin
Kevin
9 years ago

@Bella: “Is there anyone else who thinks: That’s why I pay someone to do this for me?” Bella, trusting a financial advisor to pick the right funds for you is like trusting a new car salesman to pick the right car for you. They’re operating in a perpetual conflict of interest (your needs vs. their commission), and 99 times out of 100, they’re going to act in their own self-interest. The Financial Advisor is going to sell you the funds that make him the most profit, and the car salesman is going to sell you the most expensive car he… Read more »

Kevin
Kevin
9 years ago

@Tyler: “I dont get how the same people who like to say ‘past performance is no indication of future returns’ will turn around and in the next breath say ‘so pick index funds, because the past performance of the US stock market is ~10% growth each year'” The reason is because those mutual funds are investing in the same market as the index funds. They’re not two completely separate problem spaces. They’re all buying the same stocks – but mutual funds charge higher fees. That is, if the market does in fact cease to rise, then not only will your… Read more »

Kevin
Kevin
9 years ago

@Glenn

“If the average return is 10%, why is it that the average investor typically underperforms the market by up to 15%?”

Expenses and emotional decision making. Specifically, loads, fees, and management expenses charged by mutual funds, and emotional decisions like selling stock when it plunges, and chasing winners after they’ve already had their skyrocketing growth.

Nicole
Nicole
9 years ago

@39 Bella Oh NO!!! Don’t let this article make you feel like you can’t manage your own funds! That’s horrible! No no no. He’s not only giving very complicated advice, but like Kevin says, that 5% of advice that’s all the complications is bad! You will actually do BETTER on average if you do less work than Robert is suggesting. JD has a really great article somewhere in the archives about very simple investment strategies that will match the market using Vanguard funds. Let me see if I can find it and link to it… I think he recommended VBINX.… Read more »

Glenn Dixon
Glenn Dixon
9 years ago

I think that the real trick is twofold:

1 – the typical investor will always underperform (http://www.marketwatch.com/story/american-investors-predictably-stupid-losers-2010-06-01)

2 – no one ever believes that *they* are the typical investor

It’s a vicious cycle…

C. S.
C. S.
9 years ago

So, what’s the best tool to use to track investments (stocks, index funds, etc) from multiple brokerages? I make regular contributions to several index funds at Vanguard, and I own stock at Scottrade. Is there a tool that will either automate reporting my performance or make it very easy for me to do so? I can see in both Vanguard and Scottrade accounts that my portfolio has gained $X over Y time period, but that doesn’t mean anything to me since I don’t know how those numbers are being computed, and whether they include cash contributions as part of that… Read more »

seashell
seashell
9 years ago

Thanks for this. It taught me how to evaluate my small portfolio and possibly make it bigger!

Brian R
Brian R
9 years ago

Great post! Simple, insightful, timely, and well needed. It’s been awhile since I read a pf post that I learned something from.

Kevin M
Kevin M
9 years ago

JD, You (kind of) reprimanded Glenn above for picking an arbitrary time period to compare returns of the S&P 500, but isn’t that what this entire blog post is doing? Comparing the return of your investments every year to its appropriate benchmark? Why a year? After reading this entire post, I kind of felt like it was advocating the Money Magazine strategy – chasing the hot stock or mutual fund. I also happen to agree with Tyler that index funds should not get a special pass. Yes, they are generally better than active mutual funds by virtue of their lower… Read more »

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