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Chasing Past Performance
By Ralph Goldsticker, CFA | 26 March 2019
Markets are volatile. The standard model describes an asset’s realized return as having two components:
its expected return for the period, plus …
an unexpected return.
The unexpected return, or surprise, comes from investors revising their views of the asset’s value as they digest new information, making realized returns primarily unexpected returns.
Unexpected returns are highly volatile relative to expected returns, even for multiple-year periods. There is little correlation between the unexpected return in one period and the unexpected return in the next, because:
unexpected returns are determined by events that happened during the period, and
there is little relationship between news in one period and news in the next.
As a result, the relationship between past and future returns is quite weak. The oft-read statement "Past performance is no guarantee of future results" reflects that. Yet investors still allow recent performance to shape their expectations of future returns.
For example, since 1970 the trailing 10-year stock market return has averaged 10%, while ranging from 0%–15%. We cannot directly observe expected returns, but logically they are stable. As a result, the volatility must be due to surprises, not expectations. When the stock market lost value, most of the surprises were negative. When the market gained 15%, it was dominated by good news. Similar analyses for other risky asset classes will produce similar results.
Here are three signs that you may be chasing past performance:
#1. Using the present tense
While the difference between saying “The market is going down” rather than “The market went down last week” seems minor, it may indicate a subconscious mindset to extrapolate recent performance into the future.
#2. Reacting to performance
Prices change due to news and the market’s responses to the new information. Investors may overreact, underreact, or get it right. Some investors’ first inclination is to sell after declines and to buy after rallies. That temptation to extrapolate returns implicitly assumes that the market underreacts. The better response to a large return (up or down) is to compare the change in price to the news, and then decide whether to buy, sell or hold.
The same temptation exists when monitoring active portfolio managers. A manager underperforming does not mean the investment process has stopped working. Instead, use the drivers of the underperformance to evaluate the likelihood of the manager adding value in the future.
#3. Investment decisions were pro-cyclical
Besides looking at their language and inclination, investors can look at their past decisions, both asset allocation changes and manager terminations, to gain insight into their own behavior.
In theory, changes in the strategic asset mix should be uncorrelated with recent returns. Changes in the tactical asset allocation will reflect the investor’s investment philosophy. Value investors will tend to increase holdings of assets that have underperformed. Momentum investors will tend to increase holdings of assets that have outperformed. Evaluate your past asset allocation changes to confirm that they were consistent with your investment philosophy. Modify the decision-making process if they were not.
Similar to asset class returns, there is a significant unexpected component to active managers’ performance relative to their benchmark. If you find a consistent pattern of terminating active managers after they underperformed, it’s probably a sign that the organization is placing too much weight on past performance as an indicator of skill.