Past Performance Is Not Indicative of Future Returns

SOME of the analysis in this book relies on using past returns to provide perspective on what the portfolios have done over time. Using past data to forecast future outcomes is called “extrapolative expectations”-based forecasting. In other words, we are extrapolating the past into the future. That’s a fine approach for providing a general idea of future risk and return, but good portfolio management always requires a certain degree of outright forecasting.

Some part of this will involve accepting the reality that you’ll be wrong at points. As Wall Street legend Barry Ritholtz says: “The simple reality of life is that everyone is wrong on a regular basis. By confronting these inevitable errors, you allow yourself to make corrections before it is too late.”⁸ Remember, a good portfolio is diversified, and diversification requires learning to hate some part of your portfolio all the time. Even when you’re wrong about something you tried to forecast. You’ll have to learn to roll with the punches and evolve, even when you’re wrong.

The world will change with time and your portfolio will have to keep up. This will not only require a certain degree of prognostication, but it will require a certain degree of activity. And that’s fine. I always like to say that there’s no such thing as a truly passive investment strategy, but there are smart ways to be active and silly ways to be active. Smart active looks like this: a clear plan, low fees, low turnover, and solid diversification. Bad active? That’s high fees, lots of trading, concentrated bets, and no underlying plan.

Unfortunately, almost all the data we have to support portfolio analysis is thin. The US stock market, for example, has only existed for about 100 years. In that time, it has experienced only a few dozen business cycles. And in that short time frame the US market has changed substantially from what was predominantly an emerging market in the 1800s to the largest developed market in human history as of today.

Most global markets can also be viewed within two time horizons differentiated by World War 2, which decimated many European and Pacific economies while catapulting the US into what it is today. And during the post-war era there has been just one legitimate debt deflation (2008/9) and just three legitimate inflation scares (1945–1952, 1970–1980 and 2021–2024). The point is these datasets are all very thin. They need to be treated with a certain degree of rational skepticism.

The key in all of this is to find a portfolio that is rooted in first principles, has an empirical track record, but also one that you believe is likely to perform well in the future regardless of what it has done in the past.

So yes, use all the past evidence you can to support your portfolio construction process. But also remember that the future is very likely to look different from the past. I’ve chosen portfolios that have significant historical data and sound underlying empirical support, with the hope that these factors can help us better assess future potential performance.