Not your grandfather’s market – is part performance useful at all?

Welcome to Finance and Fury. In this episode we will be doing a deeper dive into historical returns, particularly focusing on if looking at the past performance useful when selecting investments, or basing investment decisions around?

I am sure that almost every one listening has head the general disclaimers about basing investment decisions on historical performance– for instance ASIC states that disclaimers such as – “Past performance is not a reliable indicator of future performance.” or “Investments can go up and down. Past performance is not necessarily indicative of future performance.” Generally, are seen as not misleading – but these in some instances still do not adequately bring the consumers attention to the issue of using historical performance as the sole basis of making an investment decision

1. It should be noted that these disclosures are for marketing marital that represents performances of individual investment providers – say an investment manager selling a product was to do so purely based around their past 12 months performances – well this should be avoided at all costs in ASICs eyes as this would be considered misleading – as what is the guarantee that these returns continue?
2. This sort of regulation is probably appropriate for certain investments – say high risk investments that go through boom bust cycles – ones that can receive a 50% return in one year, just to be back to 0% the following – if you only represented one- or two-years’ worth of returns that are in your favour – or starting the date that returns are counted from – well this is very misleading –
   1. This is one thing to definitely watch out for – the dates that are used to represent investment returns – as when you see a 1, 3, 7 or 10 year return, look at the dates that this applies to – if it is not up to date or is selected over a certain timeframe that is favourable to the fund – this is also very misleading
   2. This actually brings up similar points to the episode from two weeks ago about chasing returns – as research shows that past performance offers little insight into a fund’s future returns as typically the best returning fund over the past 12 months fails to replicate this in the long term
   3. As humans we are hardwired to detect patterns – in life this has been part of our survival instincts – to help us predict and expect what might come next – without the experience to detect false patterns through having experience and learning from failure – this is one of the main reasons behind a trend-chasing bias
3. Beyond this – there are some problems with using part performances as an indicator for investing for future returns – and that is that times have changed – however – it should be noted that behaviours haven’t changed at all – it is simply ability to carry out behaviours is what has changed – in other words – behaviours/emotions are the same, but our capacity to act on these is what has been magnified with time

When it comes to the changes over the past 100 years – There is probably too much to cover in one episode – but as a quick summary of the vast number of things have changes, this covers things from the economy, technology, communication and the very financial system

1. There have been major changes in the economy – one of the biggest affects is the globalisation of each nations economy – where each major listed company is typically multinational – think about the biggest companies on earth – amazon, alphabet, apple, FB – these all are truly multinational companies where their end results are in part, reliant on each countries usage on their product – over time, financial markets have increased in their interconnectedness – or at the very least, their perception of interconnectedness – where someone in Australia will sell WOW in fears that the US share market is going to decline
   1. This wasn’t so much of an issue 100 years ago – prior to the age of globalisation – where companies were limited in their market caps, typically to what was demanded domestically – you obviously had export markets going on – but this is nothing compared to modern markets –
2. Changed Technology – with the invent of the internet and super computers, the access to information and speed at which trades can occur has increased dramatically
   1. Internet – this was a major game changer – rather than the average individual getting the daily price of an asset in the news paper – now it could be reached second to second – also, the access to information about everything from specific company financials, to larger macroeconomic factors is now at the fingers tips of anyone with an internet connection
      1. Going back 100 years, you essentially had to be an insider to have even part of the information that you or I would have access to today
   2. With increases in technology also came Quant trading – this rapidly increased the speed of trading and has turned into AI making many of the buying and selling decisions
      1. This has increased the volatility of the market along with the speed at which markets can drop and rise – just look at the flash crash in 2020 – and the rapid price gain that soon followed
   3. Think about as a comparison, looking back 100 years ago, where trades used to have to be made on a floor at the exchange, through a broker as a representative
      1. This created an artificial cap on the dynamics of the share market – if the price of an asset is determined by the buyers and sellers of a security – then if the number of transactions, both on the buy and sell side is limited through a trading floor – the volatility is also limited
      2. The removal of the need of going through a broker, who can only manage so many orders in one day, and to be honest will only deal with their best customers first – i.e. the ones with the most FUM

• The technology and access to making your own investment decisions is in part why so many more people own equities and other forms of listed investments compared to 100 years ago.

3. Changed financial system – and government interventions – it is hard to say if this may be the largest change – and a consequence or simply a by-product of the preciously discussed changes
   1. But I would argue that whilst the previous points discussed have allowed increased access to the average investor to act on their emptions, the changes to Central Banks involvement is the largest fundamental change in the last 100 years –
   2. The reason why I believe that this is the largest change in financial markets – first and foremost is the CBs control of money supply and the very cost of money – really ramped up since the 1990s – and particularly since 2009
      1. Measures like QE have fuelled markets – through expanding bond markets and lowering the costs of capital, asset prices were artificially distorted
   3. Changes in our communication methods – press/media and social media – in the larges part this also relates to technology –
      1. When compared to 100 years ago, it seems that everything happens so quickly – due to the news cycles – what was a major news story, taking up every news channel or social media feed will soon be old news a day or two later – this in the large part comes from the competition that being first on a news story brings – those that are first for breaking news, be it true or false, it brings major revenues
      2. This speed of communication in conjunction with technology to disseminate communication – created a myopic view – and in my view a shortening of the average individuals time horizons
      3. As an example of this – the average share holding period has declined massively over the past 60 years – From Russell Investments –
         1. 1960s 8 years and 4 months, 1970s – 5 years and 3 months, 1980s – 2 years and 9 months, 1990s – 2 years and 2 months, 2000s – 1 year and 2 months, 2010s – 4 months
         2. These results are a little insane – But they do point to the fact that the average investor is more focused on the short term, rather than long term returns

So – Whilst technology and financial markets have changed dramatically over the past 100 years – as humans, we haven’t – our emotional response to losses and gains remain the same

5. We are bombarded with more information today – and our ability to act in response to negative information, such as market losses has increased – this all can really affect our Behaviours – to become more myopic (i.e. short term focused) – interesting topic – one that deserves its own episode – is a culture of focusing on the short term and instant gratification a recent phenomenon?
6. In the current state of markets, with the technology, financial system, etc. –
   1. Wonder how bad crashes would be if a world war broke out today on a scale similar to WW2
   2. Would we see the worst market crash in history? Or would Central banks really turn on some stimulus measures to offset any losses
   3. I have done a few episodes on the economics of war years ago, but more recently returns of financial markets during war times – where the US and Aus financial markets didn’t see massive losses during times of global conflict – but again, times were different back in 1914 and 1940s

Due to this change, is looking at past performance useful for anyone? And if so, what is it useful for? In my view – historical performances are actually still rather valuable – as history has really helped to form investment principles and rules to follow –

1. After a loss, the markets will always recover the in long run – look at the return’s charts for any market – such as the ASX
   1. Not always true for smaller, or even in some cases larger companies that make up an index
   2. Having a diversified investment portfolio in high quality assets should see a recovery in the long term after a loss
2. It helps with comparing returns between asset classes and building portfolios – such as the fact that the share market is expected to outperform cash or bonds over the long term, say 10+ years
   1. This is where past performance gives a good snapshot of how asset classes perform – where some asset classes receive lower long term returns due to not having a growth component –
3. It also helps to compare returns within asset classes – such as bonds with higher default risks providing higher yields, or that quality mid-cap shares that have positive cashflows can outperform their large cap counterparts in the long term

Instead of looking at purely past performance – selecting an investment allocation will differ for everyone – this is due to needing to have a more measured method on how to select investments

1. But the very first step – which has been mentioned in many previous episode is to look at your investment goals and investment time horizon
   1. Before making any investing decisions – you need to fully understand your current financial situation – in other words, you need to be clear and understand what your money is being invested for
      1. This helps to determine when you might need your money back, if at all – this is the concept of a time horizon for your investments – if you need all of your funds back in 12 months to two years to fund something like a home deposit, then investing these funds can often be the incorrect decision –
      2. You can get lucky, but if past performance fails to materialise, then you may end up with less capital than you originally had
   2. You also need to look at your tolerance to risk – All investments have some degree of risk – even bonds, which are considered lower risk have seen larger losses than many share funds recently – meaning that regardless of where you invest your funds, some losses are always possible

In summary –

1. Past performance isn’t that useful in the short term – returns received have been due to a number of factors, many of which may not be repeatable year on year
2. Especially as technology and financial markets have changed
3. Instead of basing an investment decision based on past performance – I find that using market principles based on evidence can be a more appropriate method when selecting investments
   1. So instead of looking at what the market did in the short term and investing hoping that the market continues to behave in this way – making an investment decision based on what you need from your allocation and matching this to your goals can help to achieve a better desired result
4. We will do another episode to look at this