We have all heard the statement that “past performance is not an indicator of future returns” from financial providers. But what does this statement actually mean? And why is it that it stands true? Let us explain.
Our ability to detect patterns is a strong skill that allows us to see order in randomness. It allows us to predict what might come next and to complete a picture in our heads.
We often believe in patterns that we find. This behavior, which is hard-wired into our genes, is essential for learning and making decisions. However, it is also the reason behind a common bias in the investment world, known as “trend-chasing bias.”
Trend-Chasing Bias
It refers to the tendency to buy assets that have had good returns in the past and to sell assets that have had poor returns in the past. A key component of trend-chasing bias is the belief that what has already happened will keep happening.
There are other cognitive biases that can contribute to someone chasing trends, such as the belief that they have more control over events than they actually do, and confirmation bias, which is the tendency to only notice evidence that supports their existing beliefs.
These biases can cause people to overestimate their role in predicting random events, like stock prices, and underestimate the role of luck.
Although it is often said that you cannot predict the future by looking at the past, we still believe that this is possible.
The irony is that this “herding” can extend the trend. This is because enough people acting based on the trend and following the actions of others will continue the trend.
“Past performance is no guarantee of future results” is generally treated as a warning label: Don’t assume an investment will continue to do well in the future simply because it’s done well in the past. “Past performance is no guarantee of future results.”
Don’t just write off an investment because it hasn’t been doing well lately, there’s always a chance it could rebound. “Past performance is no guarantee of future results.”
The phrase might be trying to warn us against buying too much on credit.
We believe that too much focus on U.S. equities is unwise and advise selling non-U.S. positions. By now, everyone has heard the case and seen the numbers:
The 10-year stock market return for U.S. equities has been extraordinary. U.S. stocks–large cap growth stocks in particular–have outperformed every other major asset class in every standard time period as of September 30, 2018.
Since it’s easy to continue selling portfolios that are heavily tilted towards U.S. equities, this is something that will likely continue happening in the future. Investors are more likely to invest in an opportunity that has been doing well recently.
Even though the U.S. is doing well compared to other regions, its valuations are stretched compared to its own history.
This situation has traditionally been risky for investors, as it has the potential to result in significant losses.
So, what are the alternatives? In our view: International developed and emerging market equities. The valuations of these companies appear to be more attractive, and their fundamentals are getting stronger.
There is a discrepancy between how investors portfolios are allocated to different regions. Consider the breakdown of market capitalization as represented by global indices compared to how investors are actually allocated based on assets that are held in U.S. open end mutual funds and ETFs:
According to MSCI, international developed equities make up 34% of all market capitalization, but according to Morningstar, only 17.7% of U.S and non-U.S equity mutual fund assets are in this category.
Emerging markets represent 11% of market capitalization3. Even though only a small percentage of assets are invested in emerging markets funds, there is still potential for growth in this area.
While US stock markets make up 55% of the global opportunity set, 77.5% of assets across global equities are represented by US home market mutual funds and ETFs.
Many U.S. investors don’t invest in international or emerging markets because they believe there are more risks associated with these markets.
But, those reasons are likely compounded today. Why is that? Many people believe that it is difficult to make a profit by buying stocks when they are low in value and then selling them when they are high in value.
This is exactly what investors in international and emerging markets are currently having to do. It’s hard to accomplish because:
The challenge of identifying winners early requires a lot of intellectual capacity and foresight.
A bigger challenge than what is behavioral? The challenge is to be contrarian and invest in something when others do not see the value and to have the patience to wait it out.
Encouraging clients to invest in something that is doing well and has good short-term prospects is easier than trying to interest them in something else.
You will need to spend more time convincing potential clients to invest in an asset that has recently not been performing well, but which you believe will turn around soon. Your clients will need to trust you in order for them to make this investment.
It’s more challenging than ever in today’s 24/7/365 news cycle to have the patience required for success. Many investors today see a multi-asset portfolio as something that is only relevant for a short amount of time.
Even though some investors may tell their advisors that they are in it for the long haul, they frequently check their account values online. The numbers below are shocking, but they’re not surprising.
It is unfortunate that more information does not lead to better decisions or outcomes for investors. Rather, it tends to breed impatience.
Clients rarely called to thank you for their investment exposure in 2017 when emerging markets led the way at +37% and developed international markets at +25%.
Although they refrained from asking about changes in strategy this year, in other years, like 2018, they were quick to point out when international and emerging market performance turned red.
One way to change the discussion with clients as you head into the 2019 business planning season is to look at your client’s portfolio allocation.
Do the current allocation plans still fit the needs of the client, given their stage in life? For example, does your original 60/40 balanced portfolio still reflect a 60/40 risk tolerance?
Do clients fill out investor profiles differently today than in 2008? Some people say that the current risk tolerance is now 80/20, with 80% of people being more risk-averse than they were in 2008. Don’t forget that investment markets have been very unusual during the past 10 years.
Chasing Past Investment Returns isn’t a Good Idea
Focusing only on historical data when making investment decisions is not a viable long-term solution.
One clear example is the dot-com crash in the early 2000s. Investors started to speculate on Internet companies in the mid-1990s, even though many of them had yet to make a profit.
The focus was on their potential for great things and assumptions that they would be adopted and expand.
Utilizing the price trend as a guide, investors bought shares in various dot com companies with the intention of making a profit. However, when the Tech bubble burst between 2001 and 2002, many of these Internet companies failed.
Even the surviving ones took a huge hit. It took nine years for the stock to return to that level Amazon’s stock price fell by over 90% from its peak in April 1999 and took nine years to return to that level.
Some product issuers advertise their investments that have done well in the past to attract investors, knowing that many inexperienced investors are likely to follow trends.
If you google “investment returns,” you’ll find multiple companies promising high returns to lure you in.
Market movements are much more random than people want to admit.
If you identify a trading pattern, it’s likely that other market participants, like institutional investors, have already found and taken advantage of it. If you focus on that identified trend, you might buy at the market peak.
Considering Other Options
Before we give you our recommendations, it’s important to remember that a fund’s past excellent or poor returns do not necessarily mean that the performance will persist over your investment horizon.
You can expect there to be some difficulties along the way, but that doesn’t mean that these indicate a trend towards failure or success. With that in mind, here are a few key indicators that you might find helpful when making an investment decision:
Your Investment Goals and Investment Time Horizon
Before you invest, look at your financial situation and figure out what you can afford.
It is important to understand what your money is invested for as this will help you to know when you will need all or some of the money back.
Your investment time horizon is the amount of time you are willing to wait for your investment to mature. This is important to know because it will help you determine what percentage of your money you should invest in stocks as opposed to bonds.
Some investments are more suitable for longer time horizons because you can afford to ride out the market fluctuations when there is more time remaining. Other investments are more suitable for the short-term because the stability is more important.
Your Comfort Zone in Taking on Risk
All investments come with the possibility of losing money. The greater potential investment return is the reward for taking on an additional level of risk.
It’s important to understand how much risk you’re comfortable with when making investment decisions, so you can stay within your limits when market conditions are unfavorable.
Many factors can go into identifying the level of risk tolerance, for instance:
How much you can afford to lose and still make a profit, your earnings potential, and; the stability of your income and other financial assets.
Diversification
This means that you shouldn’t put all your effort into one thing, because if it fails, you will have nothing. Consider diversifying your portfolio across markets, sectors and stocks. Doing so can help protect against significant losses.
Favorable market conditions can vary from country to country during any given period of time.
In the same way, market conditions that make some industries do badly don’t automatically make other industries have bad returns. This means that if you invest in different types of assets, you are less likely to lose money in total.
If you’re not sure how to invest your money, buying a share in a well-diversified index fund can be a good place to start.
This investing strategy can help you find companies that have potential that investment professionals have not yet recognized.
Do not fall for false diversification, as it can actually increase the concentration of products, rather than reducing it. More funds is often always better.
Risk-Adjusted Returns
Many investors often rely on past returns to choose individual stocks or funds, thinking that if a stock or fund did well in the past, it will continue to do so in the future. Many people fail to realize how unstable investment returns can be.
In order to make a well-informed investment decision, you must be able to discern whether the increased risk is worth the potential rewards.
What do we mean by this? Let’s take a look at an example…
Let’s suppose you have two funds. Over the past 10 years, fund A earned an annualized return of 6% while fund B gained an annualized return of 12%. The returns of fund A had a standard deviation of 8% while the returns of fund B had a standard deviation of 15%.
On a total return basis, fund B outperformed fund A, but when the volatility of fund’s returns is taken into account, it is still the case?
There are a couple different ways to measure how much return you’re getting for the amount of risk you’re taking, and two of the most popular methods are known as the Sharpe ratio and the Sortino ratio.
The Sharpe ratiois a measurement of risk-adjusted return that is calculated by subtracting the return of a risk-free asset from the return of the fund being measured, and then dividing that result by the standard deviation of the fund’s returns.
Conclusion
Trying to help clients understand that “Past performance is no guarantee of future results” can be more difficult and less common than just focusing on the latest winning investment.
be challenging and less common. If this is the path you are headed as an advisor, and is the path you are guiding your clients, you can be assured that you won’t be alone. Russell Investments will go down that road with you.
Our job is to allocate multi-asset portfolios for the next 10 years, not to live in the past. In other words, skating to where the puck is going to be is equivalent to investing in non-U.S. developed and emerging market equities.
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