Weekly Update 6/1/2018 Past Results are Not Indicative of Future Performance

Weekly Update 6/1/2018 Past Results are Not Indicative of Future Performance

by Zach Marsh on Jun 19, 2018

Calibrate Weekly Update
Weekly Recap
S&P 500  +0.47%
10 Yr US Treasury +0.25%
Gold    -0.66%
Volatility  3.47%
Past Results are Not Indicative of Future Performance
The title of this week's letter is an often utilized disclosure that follows most investment related sales pitches or commercials.  You are all familiar with this scenario: first you see how tremendous an investment has performed, only to be fed the disclaimer that past results do not guarantee future success.  I imagine that the hope is that we are all so impressed with the past performance that when we get to the disclaimer we just say, "Yeah, yeah, yeah.  Just gimme some of that good stuff."  But, perhaps, we shouldn't be so quick to dismiss it.  Within this disclaimer is an important question:  how do we know what is repeatable and what is not? 
Here is the conundrum:  every investment strategy that has been researched has good past performance, yet not all strategies go on to have good future performance.  It's called Survivorship Bias.  No one ever sits down with a prospective client, business colleague, or member of the Joint Chiefs of Staff and says, "Well, this has had extremely mediocre results in the past, but I say 'What the hell, let's give it a shot'."  People only present "good" ideas to others whom they are trying to convince or persuade.  Good ideas can be a strategy which provides a solution to a clearly defined problem, or a systematic strategy which addresses an undefined, or unknowable future.  Long-term investments or financial planning solutions fall into the latter category.  We don't know what problems may arise in the near or distant future, and when those problems do arise it is usually too late to react, therefore we need to have in place a solution for most times.  Solutions designed to work the majority of the time are, generally reliant upon past performance results to illustrate value.  So, the question I'm continually asking myself and challenging myself with is, "How do I know what is reliable and what is not?" 
"We can never know what to want, because, living only one life, we can neither compare it with our previous lives nor perfect it in our lives to come."
Milan Kundera
The Unbearable Lightness of Being 
In my very first weekly letter back in January I referenced this quote, and I found myself thinking of it again.  Since the time I first read this novel, the quote has haunted me, for what it implies about all decision making and the tendency towards inaction.  On the one hand, with an investment strategies we can "compare it with our previous lives," that's what all this data provides.  But on the other hand, we can never be certain about the validity of the comparison because we can never be sure about what constitutes a reasonable sample size.  Twenty years seems like a long time, but in the context of our lives it may only be a quarter of our time.  The Houston Rockets were leading Golden State 39-22 after the first quarter in Game 6 only to lose by nearly 30 points.  So, it appears that maybe a quarter isn't so long.  What about 100 years, surely that's enough time?  A hundred years encompass a broad range of events and economic highs and lows in American history.  But what if we examined our reference point.  Sure there have been traumatic events in the last 100 years which provide stress tests for investment strategies, but that is still relatively limited.  On October 19, 1987 the Dow Jones Industrial Average fell 22.61% in a single day, a record unmatched in US history.  To this day it serves as a reference point for how far and fast the stock market can correct.  But can we, necessarily, view it as the deepest depths?  After all, prior to that day, the worst one-day performance in the market was down 12.82%.  For 58 years that day served as the stress-test level for investment managers everywhere, only to be proven inadequate, years later, in dramatic fashion. 
So, perhaps we can never truly know what to want, or what to do when it comes to investing, but that doesn't mean we should do nothing.  Doing nothing is a guaranteed failure.  Inflation and expenses have a great way of eroding net worth and forcing us into action.  As Tim Geithner once said, "Plan beats no plan,."  We need to develop a strategy, and that strategy must have some reference to our "previous lives," but not dependent upon the events playing out in exactly the same way or sequence.  One method of eliminating sequence of return dependency is to submit the strategy to Monte Carlo testing.  Monte Carlo randomizes returns and spits out 10,000 different possible outcomes based upon the criteria of average return and volatility.  It isn't without its faults, namely a dependency upon normal distribution of returns, but it does provide a projection based upon a resemblance of the past and not a replication of it.  Another method we implement is a test utilizing rolling 36 and 60 month periods of return and volatility.  Investments that have shown more consistency over a wide variety of entry and exit points should prove to be a better longer term investment for years to come.  Let me show you an example of this graphically.  Below are 3 different investments going back 21 years.

The superior past performance of Portfolio 3 is clear, it's choice for the next five years may seem obvious.  But, herein lies an example of Timing Bias.  Below is a graph of the same 3 investments, but instead we start in 2000 and end in 2011.  The change of perspective is significant. 
The clear choice from the first graph has fallen from a massive out-performer to the laggard of the three.  This insightful for one reason in particular, while larger time horizons and sample sizes are generally preferred, much can be obscured in a large array of data.  What was hidden in the top graph was that Portfolio 3 lost over 93% of its value in a two year period between 2000-2002, essentially invalidating it as a standalone investment choice.  By the way, Portfolio 3 is Amazon stock and the other 2 are some portfolios that I have been tinkering with recently.  Below, I've shown a more realistic analysis comparing my two portfolios against a 60/40 portfolio. 
While both portfolios massively outperform a traditional 60/40 portfolio, it is important to search for potential dangers that may lie hidden in the weeds.  When analyzing the results, we dissect the investments over all 60-month rolling periods, We find that unlike the Amazon example, there is not a single 60-month period over the last 21 years in which Portfolio 1 and 2 have not outperformed the traditional 60/40 investment.  There is also not a single 60-month rolling period in which either Portfolio 1 or 2 had negative returns.  This can help us gain more confidence in those 2 portfolios as viable investment strategies. But while this provides us with powerful data for future implementation, we are still always searching for potential dangers to investment strategies.  The greatest threat to success in investing can be arrogance of thought, or failing to search for ways that your beliefs may be wrong. 
That's it for this week folks.  Thanks for reading.  Thanks also to PortfolioVisualizer.com for the above graphs. 

Zach and Dave


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