How I beat the S&P 500 five years running and why you should (and should not) be impressed

I have not only beat the S&P 500 the last five years, I’ve clobbered the S&P 500. The S&P 500 has returned about 14% annually since 2003.

While working on some posts about my investments for The Dough Roller, I set about calculating my returns for the past five years. I even had to order some old brokerage statements to get information back that far. The result? I clock in at just over 20%. Now I could pretend that I'm a brilliant stock picker, but I only invest in mutual funds. So I could pretend I'm a brilliant mutual fund picker, but that would be just plain silly. Instead, here's how I did it and why you should (and should not) be impressed.

If I got anything right it was picking a moderately aggressive asset allocation and implementing it with low-cost index and actively managed mutual funds. I will be describing my investments in detail over the next week or so. If you take the time to read The Dough Roller, I believe you have a right to know exactly where I put my money.

So I’ll be telling my investment story over the next few weeks. But for today, it’s enough to know that I put a significant amount of my investments in international stocks (including emerging markets), REITs, and small company funds. Over the past five years, this allocation has outperformed the S&P 500 for several reasons:

1. International stocks, particularly emerging markets, have done extremely well. Most of my emerging market investments are in Vanguard’s Emerging Market Stock Index (VEIEX), which has returned about 38% a year over the last five years. If you look at the history of emerging markets, however, you’ll note that they can lose money about as fast as they can make it. If you invest in emerging markets, fasten your seat belt. Of course, for me they accounted for about 15% of my portfolio (10% today), so the volatility of emerging markets in my entire portfolio was muted.
2. The falling dollar has helped many non-dollar denominated assets for US investors. If you ever wondered how the falling dollar affects foreign investments, it's really quite simple. Imagine for a moment that one dollar is worth one EURO. A US investor exchanges $100 for 100EURO and invests the money in a stock. Assume a year later the price of the stock hasn't changed, but now it takes $2 to buy a EURO. Now that 100EURO stock is worth $200. The change hasn't been that dramatic, but the falling dollar has accounted for a significant portion of the increase in value of my international stocks. Of course, what the currency market giveth, it can easily taketh away.
3. REITs have returned a princely sum (until this year, anyway). This year my REIT fund, Vanguard REIT Index (VGSIX) is down about 11%. But in the previous four years, it was up each year in double digits and exceeded 30% in three of those years. As part of rebalancing my investment portfolio, I sold some of this fund early in the year, so the decline hasn’t hurt me as much as it could have.
4. I invested in value-oriented mutual funds, which did well during four of the last five years. My main investment hear is Dodge and Cox Stock Fund (DODGX). Although it has lagged the S&P 500 in 2007, it outperformed the market during the previous four years. Value won’t always beat growth, but it has recently.

So why should you NOT be impressed?

At least two reasons. First, returns by themselves don’t factor in the risk we take to attain those returns. You can calculate risk-based returns, but without doing the math, it’s clear that my portfolio is riskier than the S&P 500. Second, my portfolio won’t always beat the S&P 500. It has recently, but I guarantee I won’t be earning in excess of 20% year in and year out.

So why should you be impressed?

Hopefully, for the exact same reason, you should be impressed with your own investments. I stick to a reasonable asset allocation plan. I don’t buy into a rising market or sell into a falling one. And I implement my investment plan with low-cost mutual funds.

I’d like to tell you that I have some deep dark magical secret to sell you. Maybe I should peddle a newsletter that costs $300 a year. The fact is, you should run from any “pay me money and I’ll tell you how to beat the market” scams. Investing doesn’t have to be complicated. There are some more heady aspects of investing that I study and even write about here (asset location, strategic asset allocation, after-tax asset allocation, risk measures, etc.), but these are not necessary to be a successful investor. Pick a reasonable asset allocation, buy low-cost funds, invest early, and invest often.