At some point, every investor with at least a little experience owning securities has heard a warning along the lines of, “past performance may not repeat.” Nonetheless, most investors at least consider past results in forming expectations about what might happen in the future. What are the potential analytical pitfalls about which one should be aware when studying the past return statistics?
First, one should consider not just the performance but the volatility of performance. Consider these two investments.
- earning a +4% return on average over ten years, with the worst year of the ten being a +3% return; or,
- earning a +4% return on average over ten years, with the worst year of the ten being a -40% return?
Both investments have the exact same average historical return; but the second investment achieves the return with much greater volatility than the first. It would be easier to assume that the first will continue to generate the same 4% return in the future because the past returns were so consistent. The same cannot be said of the second.
Next, one should consider the amount of assets invested in the strategy. Rapid asset growth could mean that it may be impossible for the money manager to sustain past performance into the future. Consider three observations:
- Most professional investors will agree to manage ever larger sums of money, because of the fees that can be charged.
- A sophisticated investor managing $10 million can avail himself of niche opportunities that aren’t worth the time of someone managing $100 billion.
- People with money tend to place their funds with investment professionals who have successful track records (as opposed to the opposite).
Taken together, it is easy to imagine the following happening. A professional investor starts a small fund and builds a good track record by investing in niche opportunities that are too small for his biggest competitors. As the public discovers his track record, the professional investor’s funds under management increase dramatically. With so much more money to manage, the professional investor cannot find enough of the niche opportunities to sustain his track record. Performance then slips into mediocrity. In this case, past performance is unlikely to not repeat.
To many people, successful investing requires correctly predicting the future. In that light, here are some memorable quotations about the pitfalls of prediction:
- Niels Bohr: “Prediction is very difficult, especially about the future.”
- Lao Tzu, “Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”
- George Savile, “The best qualification of a prophet is to have a good memory.”
- Winston Churchill, “I always avoid prophesying beforehand because it is much better to prophesy after the event has already taken place.”
- Mark Twain, “Prophesy is a good line of business, but it is full of risks. “
Given the great difficulty of predicting the future, it might be worthwhile for investors to minimize the use of predictions in their investment process. What might that look like? In general, it means focusing less on what might happen in the future and focusing more on what is happening right now.
As a practical matter, it could mean for an investor in common stocks:
- Focusing on stocks that are undervalued on a current assessment of the intrinsic net worth of the company, rather than on an assessment of the company’s intrinsic value two, three or five years in the future.
- Not assigning much credibility to a management team’s vision for the future.
- Ignoring either partially or entirely analyst earnings estimates one or two years out in the future.
- Assuming that growth rates in the future will converge towards the growth rate of the economy overall.
In short, reducing the amount of forecasting in an investment process designed to build stock portfolios may mean adopting the behavior of a value investor. It is not possible to eliminate all predictions from investing. But where predictions must be made, the prediction-averse value investor should choose adopt a conservative (i.e., either pessimistic or worst-case) view of what might happen.
Colors can trigger emotional responses. For example:
- As the color of the sun, yellow is sometimes associated with happiness
- As the color of the sky, blue may create a calming effect.
- As the color of nature, green may evoke harmony and peace
- As the color of fire, red may create a sense of danger and of aggression
It seems customary that financial websites display positive changes in the value of investment in green, but show negative changes in red. Does the use of color in showing price changes alter how investors perceive investments?
In a recent paper (“In the Red: The Effects of Color on Investment Behavior“), William J. Bazley, Henrik Cronqvist and Milica Milosavljevic Mormann suggests that colors do affect perceptions about investments. According to the paper’s abstract,
… we find that when investors are displayed potential losses in red, risk taking is reduced. Second, when investors are shown past negative stock price paths in red, expectations about future stock returns are reduced. Consistent with red causing “avoidance behavior,” red color reduces investors’ propensity to purchase stocks. The findings are robust to a series of checks involving colorblind investors and alternative colors to control for salience effects…
The implications of this study are worth considering. Most people understand that the emotional shock of a large monetary loss can affect judgment. When people witness a large decline in the value of their stock portfolio, they may freeze up. Or they may panic and sell everything at the worst possible time.
People who have managed to sell before a big market decline are not immune to the emotional baggage of a bear market. Seeing the damage, they may find it difficult to step back into the market.
Coloring all this information in red may make matters worse for investors who are attempting to stick with an otherwise sound investment plan, or take advantage of the opportunities that the market presents.
People often use their past experiences as a guide to developing expectations about what might happen in the future. But people have many past experiences from which to choose. In attempting to understand what might happen in the future, do people select the past experiences that are most relevant? Or do they use some other criteria?
The evidence suggests that when in doubt, people tend to turn to their experiences in the recent past. Psychologists refer to this phenomenon as recency bias.
For example, in evaluating the future prospects of stocks, the average investor will tend to assume that recent performance will continue. Thus, if the stock market recently has been moving up, then the average investor will tend to think that the stock market will continue to move up. If recent experience shows unusual volatility, then the investor will tend to assume that the unusual volatility will continue.
Experienced investors can be influenced by recency bias. Most experienced investors know that future stock returns are shrouded in uncertainty. Such investors may think in terms of a range of outcomes rather than in a simple extrapolation of past results into the future. But even for experienced investors, recency bias can cloud judgment. This bias may cause investors to shift the range of expectations according to recent experience. For example, if stocks have performed well recently, the experienced investor may continue to acknowledge the risk of losing money while adjusting downward his subjective assessment of the likelihood of such losses.
An awareness of recency bias may be beneficial for investors. Recent performance may or may not tell us much about future performance. Knowing this may help the investor avoid becoming overconfident in his expectations about the future, and thus avoid committing too much capital to an investment idea with uncertain prospects.