2017 was another year of above-average investment returns in what is now a very old bull market.
As with previous year-end reviews, I’ll review my model portfolio’s performance against its various goals as well as the performance of the individual stocks I sold in 2017.
Here are the goals I’ll be measuring the portfolio against:
- High growth: Higher total returns than the FTSE All-Share over five years or more
- High yield: Higher dividend yield than the FTSE All-Share at all times
- Low stress: Volatility and price declines should be smaller than the FTSE All-Share over five years or more. Only one buy or sell decision should be made each month
- Low risk: Keep company-specific risk low through diversification and valuation risk low by only holding attractively valued companies
- A million within 30 years: Grow from £50,000 in 2011 to £1,000,000 within 30 years (requiring an annualised total return of at least 10%)
High growth? Yes – Beating the market over the long-term
In 2017 the model portfolio produced total returns of 17.5% compared to 14.5% for its Vanguard All-Share tracker benchmark.
Those results are more than double the long-run annualised return for UK stocks, which is about 7%, so clearly this was a good year to be in the stock market.
The longer-term results are also above average for both portfolios, with annualised returns since inception (in 2011) of 11.3% and 8.6% for the model portfolio and its All-Share benchmark respectively.
Overall I’m pleased with the portfolio’s rate of progress, with annualised returns almost 3% ahead of the market. That’s a performance gap which I think could be sustainable over the long term.
Dividend growth in 2017 was also in double-digit territory, coming in at just over 19% for both the model portfolio and the All-Share tracker.
For me, dividend growth is more important than growth in the value of the portfolio. Dividends are the foundation of company valuations and price increases without dividend increases are no better than castles built on sand.
Both portfolios reinvest their dividends, so here’s a chart of how much has been reinvested each year since 2011:
Both the model portfolio and the All-Share tracker have grown their dividends by about 10% per year since the first full year of dividends in 2012, so by that measure, they’re neck and neck.
Personally, I don’t think the All-Share will maintain that sort of dividend growth rate over the long-term.
High yield? Yes – Both the market and the portfolio have decent dividend yields
The current dividend yield for the portfolio is 3.9%, slightly higher than the All-Share tracker’s yield of 3.4%.
The portfolio’s approximately 0.5% dividend yield advantage has been maintained since inception, so it’s comfortably met its high yield target.
It’s also nice to see that the index tracker’s yield is still a very reasonable 3.4%. Some investors think the UK market is overheated because it’s at a record high, but I don’t think that’s true.
The market price may be at a record high, but so are its dividend payments. And with a yield of 3.4%, which is above the long-term average, I think it’s hard to say the All-Share is seriously overpriced.
Low stress? Yes – Volatility and price declines are much lower than the All-Share’s
Price volatility is often used as a measure of risk, but I prefer to use it as a measure of how much stress the investor has been exposed to.
If an investment goes up and up and up, then most investors would see that as a low-stress investment (think about how relaxed Madoff’s investors were, thanks to his “fund’s” clockwork-like 1% per month returns).
Contrast that with an investment such as The Restaurant Group (which I hold), which went from 375p in 2007 to 100p in 2008. That would have been massively stressful for many shareholders, even though the shares subsequently rallied to more than 700p in 2014.
Of course, some lucky investors are able to completely ignore share price volatility. I certainly try to ignore share price volatility, but it still affects me, although I think I’m less affected than most.
Here’s Buffett on the topic of volatility and risk:
“It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities… If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things.”
So volatility is not risk, as long as you can stay invested over the long term and not panic sell when things turn south.
But volatility is still stressful, and personally, I’d like to reduce it as much as possible.
And on that front, the portfolio has done reasonably well.
For example, since inception, the standard deviation of one-year returns for the model portfolio has been 6.8%, lower than the All-Share’s 9.5%.
And this lower volatility of returns isn’t just because the portfolio’s returns are lower.
In fact, the portfolio’s average rolling one-year return has been 12.2%, higher than the All-Share’s average of 9.7%.
Another measure of stress is the aptly named Ulcer Index. This measures the size and duration of any price declines from a previous peak.
As with standard deviation, the Ulcer Index for the model portfolio is lower than the All-Share’s, at 2.1% and 4.3% respectively.
What that’s saying is that the model portfolio typically declined by smaller amounts and for shorter periods than the All-Share, which sounds like a good thing to me.
More specifically, since inception:
- The portfolio’s largest decline has been 8.1% compared to 13.5% for the All-Share
- The portfolio’s longest period “underwater” was eight months compared to 15 months for the All-Share
So the model portfolio has been a less stressful investment to watch than the All-Share, but what about individual holdings?
To be honest, extreme volatility at the individual company level is virtually inevitable. Even with super-defensive stocks, you can still see massive share price swings.
A good example of a volatile defensive from the model portfolio is Centrica (the company behind the British Gas brand) which fell just over 40% in 2017. So investing in defensives is no defence against share price volatility.
The only sane answer is to simply ignore share price movements as much as possible, other than when you’re making pre-planned (rather than knee-jerk) buy or sell decisions.
In my case, I make one buy or sell at the start of every month and then try to ignore the portfolio’s individual holdings for the rest of the month.
When it comes to share price movements, ignorance is often the best policy, at least if you value your sanity.
Low risk? I think so, but without a bear market or recession it’s hard to tell
I’ve already said that volatility is not risk. So what is risk?
Risk is the product of the probability of a bad event happening and the magnitude of that event.
So if I eat a cheese sandwich there is a chance I’ll choke to death (a bad event of large magnitude, to me at least) but the odds of that happening are so vanishingly small that I don’t consider eating a cheese sandwich to be a high-risk activity.
In terms of investing, risk is the failure to reach your long-term investment goals, not how much the price of a company or your portfolio goes up or down over a few days, weeks, months or even years.
I like to break this view of risk down into fundamental risk and valuation risk:
- Fundamental risk: The risk that a company’s revenues, earnings and dividends fail to grow sufficiently over the long-term
- Valuation risk: The risk that a company’s share price fails to grow sufficiently over the long term even if the company itself does well
To reduce fundamental risk I stick to companies with long histories of profits and dividends, low debt and good profitability. I try to avoid other fundamental risk factors such as companies which are dependent on a handful of customers or a small number of large contracts.
I also know that I will make mistakes and that bad things happen to good companies, which means that some investments are going to lose money no matter how careful I am.
To reduce the impact of any losses I diversify across many companies that operate in many unconnected sectors in many different countries. Here’s what that looks like for the model portfolio:
None of these risk-reduction techniques can guarantee that the model portfolio will have a low level of fundamental risk. However, I do think the portfolio is, at the very least, not fundamentally riskier than the All-Share. But I’ll only really know if that is true in a) a bear market and b) 20 years’ time.
As for valuation risk, I’m a defensive value investor so of course I’m interested in buying and holding companies only when their valuations are attractively low.
It’s hard to compare the model portfolio to the All-Share in terms of valuation multiples such as price to earnings or cyclically adjusted price to earnings. That’s because the portfolio’s companies are typically faster growing than average and therefore command higher valuations (although I still think those valuations are attractive).
However, an alternative measure of valuation risk which I think can be applied is the dividend yield, which is one of the reasons I insist on the portfolio having a higher yield than the index.
And with a higher yield than the All-Share, I think it’s hard to say that the model portfolio is carrying more valuation risk than the market average.
A million pounds in 30 years? It’s still very possible
One final goal I have for the portfolio is to grow it from £50,000 to one million pounds in 30 years or less.
That sounds like a giant task, but really all I need to do is double the value of the portfolio four-and-a-bit times between 2011 and 2041.
In 2017 the portfolio managed to complete the first of those doublings when it breezed past £100,000 for the first time.
Here’s a Blue Peter-style “millionometer” showing that the portfolio is now about a quarter of the way towards its million pound goal:
What I find interesting about this chart is that it highlights how the halfway point between £50,000 and £1,000,000 is £200,000 rather than £500,000 (or more accurately £525,000).
That’s good for long-term motivation because £200,000 doesn’t seem far away now that the portfolio’s reached £100,000.
Investments sold in 2017: Some winners, some losers and lots of lessons
As usual, I sold six companies and bought six companies over the last year as part of the monthly process of portfolio improvement.
If you’re interested, here are the post-sale reviews from each company sold:
- January: Sold TP ICAP (9% annualised return over 5 years)
- March: Sold Standard Chartered (15% annualised loss over 2 years)
- May: Sold BAE Systems (18% annualised return over 5 years)
- July: Sold Morrisons (1% annualised loss over 4 years)
- September: Sold Braemar Shipping (1% annualised loss over 6 years)
- November: Sold Rio Tinto (8% annualised return over 5 years)
You may have spotted that half of those investments lost money. That is, of course, not ideal.
However, I’m not overly worried as there are two positive ways to think about investments that lose money.
First, if you are reasonably confident that your investment process is sound, then you can view a string of losses as statistically inevitable.
For example, imagine you have a magical coin. If the coin lands heads-up you win two pounds. If the coin lands tails-up you lose one pound.
The benefit of winning is twice the cost of losing, so it makes sense to toss the coin as often as possible. However, there is a one-in-four chance you’ll see two losses in a row, a one-in-eight chance you’ll see three losses in a row and a one-in-sixteen chance you’ll see four losses in a row.
If you do get four losses in a row, does that mean you’re no good at coin tossing? It’s unlikely. Does it mean the coin is broken? No. Is it simply a statistical inevitability if you toss the coin often enough? Yes.
So even if my investment process was perfect I would expect to suffer the occasional string or cluster of losses.
And when that happens I should just keep my head down, apply the investment process diligently and things are likely to work out well eventually.
The second positive way to view losing investments is to see each loss as a useful educational experience.
That’s because many losing investments contain valuable information about what to avoid, or at least what to watch out for.
If I extract any relevant lessons and integrate them into my strategy, then I would expect those lessons to significantly improve my investment strategy and my long-term results.
Some final thoughts for 2018
Neither is obviously undervalued or overvalued, so there is no particular reason, from a valuation point of view, to expect big moves up or down in 2018.
However, we haven’t had a bear market since 2008, and ten years is a very long time to go without a bear market.
The risk is that newer investors become complacent as the financial crisis passes into ancient history (i.e. outside the last ten years). These investors will only have experienced a rising market, and inexperience and overconfidence is a dangerous combination.
Personally, my preference is for a small bear market of perhaps 20% during 2018, leaving the FTSE 100 at about 6,000 rather than its current 7,500 or so.
At that level, the market would be attractively valued again, and I could work on filling my portfolio with lots of bargains.
An investor wishing for a bear market may sound like a turkey wishing for Christmas, but I’d rather have a small bear market in 2018 than several more years of double-digit gains followed by an almighty crash.