This podcast was recorded on June 28, 2016.
Alison Southwick: It's time for "Answers, Answers," and today's question comes from Jordan. Jordan writes: "Brokamp mentioned a couple of months ago that most individual investors actually lose money in the stock market, because when markets drop, many people sell everything at a loss and call it quits. My question is simple. How should I judge my investment returns?"
Jordan continues: "When I started investing, my goal was to make a profit and then I shifted to a loftier goal of beating the S&P 500. I figured if I couldn't beat the S&P, I may as well be fully invested in ETFs." Jordan's wondering if aiming for returns above the S&P is a good goal for the average investor.
Robert Brokamp: Hello, Jordan. I'm not sure I said most investors lose money. I'm certain I said that most investors actually underperform the market, as do most mutual fund managers. You're asking a great question. You're asking, essentially, "If I'm going to be picking individual stocks, how do I make sure I'm beating the market, because otherwise ..."
Southwick: Why bother?
Brokamp: "... why don't I just invest in the market and go find other things to do with my time?" It's actually a little more difficult to do than you might think, partially because people often make multiple purchases of the same stock, and then there's a question of what you do with the dividends.
Let's look at a very simple example. Let's say you just bought Berkshire Hathaway stock. Just made one purchase and held it for 10 years. It would be pretty easy to compare that to the overall market.
But what if you made 10 purchases over 10 years, and five of those beat the market, but five didn't because you didn't buy at the right time. Does that make you a good stock picker, or not?
Then there's the question of dividends. If you have a stock that pays a dividend, like [Coca-Cola] Wal-Mart, or something like that, and you look up the performance of that stock on a site like Morningstar or Yahoo! Finance, it assumes that you are reinvesting the dividends. But a lot of people don't. They either spend that cash or just let it sit there in cash.
So really the best thing to do is to take the value of your entire stock portfolio -- including the cash -- and let's say that account is maybe worth $30,000. Create a mock portfolio account using an online service like the Fool's scorecard, or Morningstar, or Yahoo! Finance. Then all you're going to do is put into that your benchmark. Most people do choose the S&P 500, so you just put in there "SPY," which is SPY. It's an ETF that tracks the S&P 500. That's the only thing that's going to be in that benchmark. You're going to put that $30,000 in there.
Anytime you add money to your actual portfolio, you also add money to this mock benchmark portfolio. If you take money out, the same way. Because then you're not looking just at the individual investments. You're looking at the growth of the value of the portfolio, and that's really what's important. You want to know if this account is growing at the same rate as if you had just put all that money in the S&P 500.
A lot of people will look at their portfolios and look at their individual holdings -- for example, individual stocks -- and say that maybe seven of them are beating the market, but three aren't, and feel pretty good about that. But if the three that are underperforming actually had more money in them, you actually may not be keeping up with the S&P 500.
Another thing some people will do is they will look at their stocks and compare them to the S&P 500, but they don't factor in the cash that they have in their accounts, and that's an important part of your overall return and your decisions as an investor. Do I let that cash sit there, or do I invest it?
That's why I like comparing the actual value of the whole account versus some mock portfolio online because it also keeps you accountable for your decisions of keeping some money in cash, because you want to play it safe, or being fully invested.
Southwick: So the SPY is the way to go, and that's essentially the S&P.
Brokamp: That's the S&P 500. The S&P 500 -- we've talked about this in previous episodes -- is an index of large-company stocks, 500 stocks. The overall stock market has thousands of stocks. I think what's really a better benchmark is the Vanguard Total Stock Market ETF, the symbol is VTI, because that includes some midcaps and some small caps. But most people do compare themselves to the S&P 500, so I think that's fine to do.
Southwick: And I think on the Motley Fool scorecard, it automatically will compare at least every individual investment. I know there have been many times when I've looked to see how my stocks have done, and I've thought, "Oh, look! I'm doing awesome." Then it says "compared to the S&P," and I then go wah-wah.
Southwick: But that's OK.
Brokamp: And you have to look at it over a longer period of time. Some people say three years. I think it almost has to be longer -- over five years. We've talked before about how small stocks beat large stocks over the long term. That's not been the case over the last five years, so you might be a really good picker of small-cap stocks, but you won't look so good, compared to the S&P 500, if all you do is focus on the last few years. If you look over the last 10 years and you still haven't beaten the S&P 500, then maybe you don't have what it takes.
Brokamp: Buy the index funds, go out, and have fun. Do other things with your time.
Southwick: There you go. Everybody wins.
Alison Southwick has no position in any stocks mentioned. Robert Brokamp, CFP owns shares of Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool recommends Coca-Cola and Yahoo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.