For many years, the phrase ‘past performance is no guarantee of future returns’ has been mandatory on promotional materials that use past performance to promote financial products – and for good reason. Playing the markets is a game based, to a large extent, on chance. Since nobody can accurately predict what the markets will do, past performance cannot guarantee future returns. But for those who choose an adviser based on the latest media hyperbole, apparently this warning does not have much of an impact.
It is well known that investors chase past returns. Our media lives on a short-cycle with specialist magazines and newspapers’ money sections carrying headlines that seek to promote the coveted ‘winners’ lists. Trying to pick one is extremely difficult; trying to consistently pick many over time is virtually impossible. It seems that even sophisticated investors become overconfident about their ability to choose a good fund manager and fail to recognise that league tables don’t add up to future performance. Decades of data clearly show that there isn’t a financial manager out there who can outperform the market year after year.
Playing the markets is a game based, to a large extent, on chance. Since nobody can accurately predict what the markets will do, past performance cannot guarantee future returns.
The psychologist Philip Tetlock, co-author of Superforecasting: The Art and Science of Prediction, has spent his career putting people’s guesses to the test and has found that, unsurprisingly, the accuracy of predictions declines as they reach further into the future, with anything beyond five years being basically a stab in the dark. Nonetheless, on shorter timescales, his research found that some people really are better at predicting than others.
These ‘superforecasters’ of the book’s title are described as analytical and numerate but at the same time intellectually humble and self-critical. They are not ideological but quick to change their minds in the light of new data and very open to different, even contrary perspectives. This is, Tetlock claims, a mindset that we can all aim to cultivate.
There are a lot of competent fund managers, but competence is not the same as the kind of talent that gives you a competitive edge. We don’t even have an agreed upon criterion for determining whether a manager is skilled. Once you’ve calculated the alpha from a series of historical returns, the question still remains as to whether it reflects real skill or just luck. People who rely heavily on forecasts seem to believe that ability plays a larger role in success than is statistically true.
We simply do not know the precise structure of the networks between companies sufficiently enough to accurately predict returns. The economy is a complex system and as such it is inherently unpredictable. Although there are no market inefficiencies, the stock market players are not efficient. The investment community is not made up of totally rational investors who jointly constitute a highly efficient information processing mechanism. Human investors don’t behave like economic calculating machines. In addition to fear and greed, there are a long list of investor biases. So, in that sense, the market is not efficient. In the real world there are bubbles, an epidemic of greed, and panics, an epidemic of fear. These are not rare – they happen every day.
We simply do not know the precise structure of the networks between companies sufficiently enough to accurately predict returns. The economy is a complex system and as such it is inherently unpredictable.
If you consider the evidence, investors cannot systematically beat the market without taking on greater risks. When a company’s earnings and the valuations of those earnings are true then the return will be as expected. Investment risk comes into play when the possibility that one or both are lower. It’s impossible to know for sure what the future holds and it’s the nature of diverse outcomes that creates investment risk. Riskier investments are the ones where the eventual outcome of faring worse is more likely than sticking to safer investments.
All together, managed funds essentially are the market. This means that collectively they hold their investments in pretty much the same proportion as a well-diversified passive fund. Therefore, on the whole they are likely to produce similar returns in the long term. It is a fundamental truth that you can’t get more out of the market than what the market has to offer. Of course, if you take costs into account, the picture favours lower-cost portfolios.
William F. Sharpe, a student of Professor Harry Markowitz and one of the originators of the returns-based analysis for evaluating the style and performance of investment funds, states in The Arithmetic of Active Management:
“If ‘active’ and ‘passive’ management styles are defined in sensible ways, it must be the case that:
- before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and
- after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar
These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”
Appointing an adviser from the new list of top investors doesn’t guarantee winning, and it may actually cost you more in fees, which, of course, will decrease your overall returns. No one can consistently deliver returns greater that what the market has to offer. However, there are forecasts that are worth making in relation to your financial planning – those over which you have a degree of influence. For instance, the age at which you plan to retire and how much money you will need to meet your future financial commitments. Sensible judgements like these are key to forming an effective financial plan that will provide reasonable returns over the lifetime of your investments. With this approach, we can aim to achieve the humility and self-reflection that may help us to become, like Tetlock describes, a ‘superforecaster’ of our own destiny.
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This article does not constitute financial advice. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner to take into account your particular investment objectives, financial situation and individual needs. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections.
