Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
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Mislead by History

July 10, 2012 - 2 comments

Imagine you are driving between Toronto and Montreal and that you have been travelling for 3 hours and completed half the journey. How long will it take to reach Montreal?

Most people would say that the past is a reasonable indicator of future performance and that another 3 hours would be a good estimation. 10 minutes later your car runs out of gas and glides to halt. Faced with this new information you might revise your estimate. Moreover, as you sit by the roadside, you might contemplate whether including information from your fuel gauge might have been a wise move when making your original prediction.

This brings us to the idea of expected returns. Expected returns are (please be patient as we get past the blindingly obvious) the return we expect on average from our portfolio in the future. Where do we get this expectation from? Often we look at the historical returns of similar portfolios. We can be a bit more sophisticated and look at the historic performance of individual asset classes (stocks, bonds) within the portfolio and average the individual asset class returns based on the percentage of each asset in the portfolio. And then we run out of gas, and our portfolio glides to halt.

Oops. We understand that markets go up and down and that what we expect to happen based on historical averages is unlikely to be repeated year after year. But as we sit by the roadside and others zip past, do we wonder whether we could and should have looked at other information than just historic returns?

Economic forecasts are popular, but what do they tell us about expected returns? To a first approximation: nothing(1). Current equity and bond market prices incorporate expectations about the future state of the economy (by estimating future cash flows), not the other way around. Hoping economic forecasts will tell you something about future stock market prices is looking through the wrong end of the telescope.

Let’s ride the car driving analogy to exhaustion and ask whether there is an equivalent to the fuel gauge to help us. To keep it concrete, consider the bonds in your portfolio - how much gas is left in the bond tank? In 2011 the overall Canadian bond market returned 9.5%. Bond returns can come from interest payments and changes in the price of the bond. Interest payments amounted to about 4% so the remaining 5.5% must have come from an increase in bond prices. In fact, bond prices have increased over the past 3 years. Over the life of a bond the capital gain has to be zero: you get only your initial investment returned, plus the stream of interest payments. The source of recent past returns provides vital information about whether the expected return is going to be anywhere close to the historic performance. As an example, one bond fund(2) that tracks the overall Canadian bond market returned 9.38% last year (by comparison the Canadian equity market lost 8.71%), with an average interest payment of 4.04%. Yet we know with certainty (barring defaults) that the future annual return from the bonds in the fund is only 2.2%. Loading up with bonds based on recent history would be unwise.

We have concentrated on bonds (and only in very general terms) to illuminate the idea that, for every asset class, understanding the components of past returns and how they respond to different risks can greatly refine our view of expected returns and how we structure our client portfolios. This clearly goes beyond a philosophy of “buy and hold” where assets are held in fixed proportions in perpetuity based on the assumption that history will repeat itself, to a more dynamic view of understanding and managing expected returns of the different assets in the portfolio. We will explore this in more detail in future articles.

1. See for example, Economic Growth And Equity Returns, J Ritter (2004) 
2. iShares DEX Universe Bond Index Fund


By: Graham Westmacott with 2 comments.
  16/07/2012 10:17:06 AM
Graham Westmacott
James, Thanks for your commment. I wouldn't discount history entirely but models, and particularly current measures ( bond yields, P/E ratios) of assets are at least as useful.
  15/07/2012 3:12:10 PM
James Alport
I've always gone under the assumption that speculating into the future based on past results was like driving a car looking at the rear view mirror. You can't do it.
Really makes the case for understanding industries and companies as a whole, better. Hence the best option is probably to read more. Ha!

Great read,


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