Investing: Should the Past be a guide to the Future?

As regular readers of Stockopedia will know, we are big believers in learning from data and statistical techniques what investing strategies have worked when. This kind of "quant" thinking is embedded in our stock reports - which feature risk indicators that have been found to be predictive like the Piotroski F-Score - and in our screening centre where we are tracking the performance of a wide range of different strategies - from Quality to Value to Growth to Income over time.

Leveraging an analysis of what's worked well in the past to develop investment and risk reduction strategies for the future makes sense to us. As George Santayana once wrote, those who cannot remember the past are condemned to repeat it.

The recent explosion of data availability and the falling cost of computing power also makes this kind of screening & modeling based on historically significant factors an important tool in the investing tool-box.

That said, it's also important to be careful with historical analysis too lest it lead you astray. It should serve as a useful device, but needs to be handled with caution too.

3 Pitfalls to be Wary Of

As wise regulators the world over like to remind us, past performance is not necessarily a guide to future performance! This counsel is of course true at many levels and there are lots of potential pitfalls in naively extrapolating from the past, including:

Mean Reversion - Far too often investors suffer from the phenomenon of “performance chasing”. As soon as they see a hot asset class or sector, they pull their money out of their other investments and pour it into the new object of their affection. That's clearly a bad idea! Markets often experience mean-reversion (this means that, when asset prices deviate too much from their long-term trend, they will often come right back - for good or for ill).

Data Mining - As we'll discuss in another article, another danger of focusing too much on the past is excessive "data mining" or confusing correlation with causation. If you look hard enough, you will likely find some seemingly effective rule that looks great, in the past. The issue is that the market has only one past but many possible futures. Even if stocks have rallied the first Friday in June for the past 30 years, it doesn’t mean they will rally again this year. It's always worth giving something the sniff test - does it make sense in the real world?

Dynamic Markets - And, of course, markets tend to be dynamic and reflexive, meaning that they can experience feedback loops which lead to changes in the behavior of market participants. If some investing approach has worked in the past, it may become accepted wisdom. Everyone piles in (think the lust for dividend stocks at the moment!). As a result, it may well become priced in / be arbitraged away and stop working.

Patterns Tend to Persist

In spite of all this, there are still important investing lessons that can and should be learnt from the past. Often, there are market structural reasons for certain anomalies - or patterns of market behaviour - to persist. On that note, it's worth remembering the words of Buffett in his piece on value investing, The SuperInvestors of Graham & Doddsville:

"[S]ome of the more commercially minded among you may wonder why I am writing this article. Adding many converts to the value approach will perforce narrow the spreads between price and value. I can only tell you that the secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years that I've practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It's likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper."

Another great example of persistence is the Accrual Effect, one of the strongest anomalies ever discovered. This work found that companies with low levels of accounting accruals (the non-cash component of earnings) tend to exhibit better stock market performance than companies with high levels of accruals. When Sloan wrote the original paper in 1997, he found that the strategy resulted in an average annual compounded return of almost 18%. A subsequent study in 2006 found that - despite widespread awareness by hedge funds and other potential arbitrageurs of the research - an accrual-based strategy still beat the market by more than 9% a year!

So History Rhymes...

The reality is that - as one blogger has sagely noted, just about everything in the world of investing is somehow based on past performance. After all, what else (other than tea-leaves) is there to base your judgements on? Every investing theory is based on past performance, from CAPM to the efficient frontier, as is just about every investing book ever written. Even the "full backing of the US Government" is based on past performance.

"I always chuckle to myself when somebody will throw out the proverbial "Of course, past performance is no indicator of future returns", like he was Moses coming down from the mountain carrying two stone tablets. Invariably, that same person will "prove" his point using...guess what....past performance".

Famed hockey player Wayne Gretzky summed up his secret to success when he said, “go where the puck will be, not where it is". This is good advice. In our minds, it's important to use the past to inform your view of the future, while always recognising that the future may be - and likely will be - unpredictably different. There's no such thing as a sure thing but you can improve your odds by learning from the lessons of the past. History doesn't repeat itself - but it rhymes.

Read More about investing on Stockopedia

See the latest Stockmarket News, Commentary & Analysis on Stockopedia