The Independent Market Observer

What Investors (Should) Know Ahead of Time

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 11, 2018 2:30:51 PM

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investorsI was thinking about demographics the other day, in the context of what they mean for economic growth over the next decade or so. One of the reasons growth has been so slow in recent years is simply because of the age mix of the population. Baby boomers are aging and retiring, so they are spending less. The rising millennial generation, on the other hand, has not yet hit its peak earning and spending years. As such, the drag from the boomers offsets the gain from the millennials. It will continue to do so for the next couple of years, but then that will change. The effect of demographics is one of the few things we really can know ahead of time in economics. We know who has been born—and when. After that, it is just a matter of counting.

That warrants (and will get) more detailed treatment. But as I was thinking of it, one more thing that we know ahead of time occurred to me, and this relates much more directly to your investments: as investors, we will get much smarter in early 2019.

The trailing numbers

How can that be? The answer is simple. Most investments report on a trailing basis, usually 1, 3, 5, and 10 years. Right now, those 10-year numbers, for the S&P 500, include the drop that really started in May 2008 at around 1,425 and continued until bottoming in March 2009 at around 683. This was a drop of more than 50 percent. Even over 10 years, that kind of drop really erodes your returns.

Current 10-year price returns are calculated on the basis of a starting point of around 1,400 and the current price of 2,758, an increase of 97 percent. That is pretty good. But once we get to 10 years from the bottom, which is to say in April 2019, that starting point will be much lower—and the gain will become more than 300 percent.

I don’t know about you, but an investor who gets over 300 percent in a decade must be better than one who gets “only” 97 percent. Stands to reason, right? That’s why I say we will all get much smarter, as investors, once that bad drawdown rolls off the reporting. Certainly, the numbers will look better.

Of course, the reality is that nothing has actually changed—just the reporting and the perception.

The takeaways

When you evaluate an investment track record, looking at the trailing numbers simply isn’t enough. Right now, looking at the past 1-, 3-, or 5-year returns for the S&P 500 gives you a very rosy picture of how the stock market works. In early 2019, the 10-year numbers will give the same picture. Does that mean the next 10 years are likely to be just as good? Many people might think so, but they would be wrong.

In investing, not only is past performance not a good guide to future performance, but it can’t be. After taking earnings growth into consideration, stocks rise because people get excited and are willing to pay more. In the jargon, this is known as an expansion of the price/earnings ratio. All that really means is that investors are willing to pay more. The more investors pay, however, the lower future returns will become. This will happen until investors get discouraged and pay less, which drives the market down and future returns up, and so the cycle starts again.

So, here’s what we know

Right now, we know that the market is expensive. We know that future returns are likely to be—indeed, pretty much have to be—much lower than they have been over the recent past. We also know that in the near future, it is going to look like we are much smarter than we thought. It would be easy to get excited and conclude that as smart as we are, we should do even better during the next decade. But that’s not how it works—and that’s one more thing we know ahead of time.

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