Wind Blown Tree

With the wind

We’ve all seen the disclaimer that “past performance is no guarantee of future results.” Yet every fund or manager shares past returns. Implicit (and often explicit, despite the disclaimer) is that this asset class, this fund, this team delivered strong results in the past and that’s what you can expect if you invest today.

But past performance reveals little about the future. And, on top of that, past returns often overstate* expected (future) returns. And they meaningfully overstate future returns at the extremes such as today.

That’s because total return has two parts:

Fundamental return + the change in valuation (of those fundamentals)

We understand this when we fly. If our plane has a significant tailwind, we’ll get to our destination faster. Or vice versa. But you can’t bet on that tailwind or headwind happening the next time you fly.

We also understand this with bonds. If you bought Treasury bonds in the early 1980s, you made a fortune as interest rates fell. You benefited from both the high interest payments and the increasing price of the bonds. But you can’t (or shouldn’t) expect those high returns to repeat once rates are near zero.

Things can go from cheap to expensive (or vice versa) once…we can’t expect valuations to travel in one direction forever. Although they often travel in one direction longer than we think they will.

We have a harder time making this connection with equities. Over shorter periods (which can be 10+ years), changes in valuation often swamp the return from fundamentals. In the Long Run Is Lying to You, Cliff Asness describes why we shouldn’t use realized returns to forecast future returns.**

Focusing on the fundamental return results in a different “answer” for the U.S. vs. the rest of the world, value vs. growth, etc. than the common narratives today. For example, say you believe the U.S. offers higher returns than Europe because the U.S. is “better.” But higher U.S. returns require that the U.S.’s relative position keeps improving vs. Europe (and that the market hasn’t already anticipated that).

U.S. large cap, growth stocks around the world, U.S. LBO, VC , etc. have benefited from this “richening” of valuations. And many have made a lot of money. But if you bet on that richening continuing forever (it has been a good bet for a long while!), you will be disappointed….eventually.

As Cliff Asness says, you shouldn’t “assume that the multiple expansion we’ve experienced is a permanent condition that should be built into future estimates.” Yet many do.

The Long Run Is Lying to You is worth a read.


*because we “see” those that have done well; underperformers are rarely highlighted.

**you can improve estimates of long run returns by incorporating valuation changes.

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