You Can’t Buy Past Returns
“What are the historical returns?”
That’s the first and often only question many investors ask before allocating capital.
Why?
Because we’re wired to believe that those returns are indicative of what we’ll receive in the future.
If something has gone up 20%, we expect another 20%.
If something has doubled, we expect it to double again.
If something has gone up 10x, we expect it to be 10-bagger once more.
The more extreme the performance, the more emotionally charged we get, and the more likely we are to buy at the worst possible time.
History is littered with examples…
1) Tech Bubble
In the five-year period from 1995 through 1999, the Nasdaq 100 gained 817%, an annualized return of over 55% per year.
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Tech stocks were all the rage, and many new investors were buying in with the expectation of similar future gains.
What happened next?
The Nasdaq 100 fell over 56% in the subsequent 5 years, an annualized return of -15% per year.
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2) Housing Bubble
In the five-year period from 2002 through 2006, home prices in Miami rose 126%, an annualized return of over 17% per year.
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The housing mania was widespread, but no market was hotter than southern Florida, with many investors buying multiple homes in the area in search of future riches.
What happened next?
US home prices plummeted, and Miami prices fell harder than almost anywhere else, down over 50% in the subsequent five years.
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3) Peak Oil
At the end of June in 2008, Crude Oil stood at $140 a barrel, 335% higher than it was just five years earlier.
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Many came to believe in a theory (“Peak Oil”) that Crude Oil production was in the early stages a permanent decline, and speculators rushed in to buy with reckless abandon.
What happened next?
The global recession worsened, and the price of Oil quickly crashed over 70%. Five years later it was still 28% lower than its 2008 peak, and it remains below it today.
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4) Gold Mania
In the five-year period ending in August 2011, Gold rose 192%, an annualized return of nearly 24% per year.
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The financial crisis, endless quantitative easing, and 0% interest rates – the macro narrative couldn’t have been better and investor demand for Gold soared, making the Gold ETF (GLD) the largest ETF in the world in August 2011.
What happened next?
Gold prices fell 28% over the subsequent five years and did not hit a new high again until 2020.
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5) Growth Stock Bubble
At the end of January in 2021, the ARK Innovation ETF (ARKK) was up over 785% in the prior five years, an annualized return of nearly 55%.
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Billions were pouring in the fund each week and it became the largest actively managed ETF in the world. Flows, of course, followed performance, as they always do. Nearly 90% of the fund’s inflows had come during the previous year (during which the fund was up 174%) with more than half of those flows coming in just the previous 3 months (during which the fund was up 56%).
What happened next?
The fund has declined nearly 60% in a little over a year, its largest drawdown to date.
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The names change in every cycle, but the underlying story remains the same: you can’t buy past returns.
In purchasing the hottest investment today, you don’t receive its coveted historical track record. Instead, you’re more likely to experience the most powerful force in markets: reversion to the mean.
The very best performing assets of the past often go on to become the worst, and vice versa. This is true of funds as well, where top decile funds tend to underperform bottom decile funds going forward (see study).
How can an investor avoid the siren song of outsized performance?
–First, by learning the countless lessons of history, a few of which I’ve chronicled here. Chasing outlier returns has cost investors dearly, adding risk to their portfolios at the worst possible time.
–Second, by staying grounded and sticking to a plan. For most, that means maintaining broad diversification (across asset classes, geographies, styles, and strategies), rebalancing at times to reduce risk, and not letting your emotions (fear and greed) get the better of you.
–Third, by using factors other than past performance (which is not predictive, as we have seen) to make investment decisions. The key question: what value does this holding add to my overall portfolio, and how will it increase the odds of me achieving my goals?
The next time you’re tempted to go all-in on the latest investment fad, run through this checklist. And say out loud what you know to be true: “you can’t buy past returns.”
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