April 05, 2019
With the first quarter of 2019 wrapped up, a headline-level statistic emerged. With a 13.1% gain, the S&P 500 index had its largest first quarter jump in 21 years. Every sub-sector within the S&P was up over 7% with the exception of health care (1).
A blip in time in the financial world, a calendar quarter doesn't mean much. But it's interesting when considering the negativity that surrounded the markets over the holidays. That sentiment turned out not to be predictive, at least in the short term.
One of the tougher problems we face on the investment side is deciding how, and to what degree, historical performance should influence investment decisions. It is easy to take a set of data and backtest it, look at the result, and say "This happened for a long time, it will likely keep happening." This conclusion often would be correct. But not always.
The problem with backtesting is that it's tempting to look for the result you desire. This is a natural tendency, and it is hard to ignore. Political news empires depend on this - they know the ideology their readers want to hear, and the reader will only absorb that which reaffirms their pre-existing belief. Seven years ago Buffett wrote in his annual letter,
“I ask the managers of our subsidiaries to unendingly focus on moat-widening opportunities, and they find many that make economic sense. But sometimes our managers misfire. The usual cause of failure is that they start with the answer they want and then work backwards to find a supporting rationale. Of course, the process is subconscious; that’s what makes it so dangerous.”
Professor John Ioannidis at Stanford published a paper in 2005 which has become the most downloaded paper from the research journal PLoS Medicine, titled "Why Most Published Research Findings Are False" (2). A primary driver, he noted, was that professional researchers know where they want to end up before they begin.
Why does this matter to us? Let's use an example. Take the year 1958. The microchip was invented that year at Texas Instruments, and Gerald Holton created the peace symbol, so things were happening that were new. But as an investor looking for yields, things appeared monotonous. The average yield on common stocks exceeded that of low-risk, high grade corporate bonds with only three transitory exceptions from 1871 to 1958 (3). If you had backtested that, you would have believed you knew what the future held.
You didn't. It reversed in 1958, and the trend has never returned.
In Vermont, it's common to see a bumper sticker that says "Not All Who Wander Are Lost." There is validity in this when it comes to financial research. If you decide where you are going to end up before you begin, chances are you'll be lost.
(3) "Against the Gods - The Remarkable Story of Risk" by Peter Bernstein, p. 334