I recently stumbled across a recommendation for young people to invest all their money in the S&P 500, an index of 500 of the largest companies listed in the United States. This recommendation was based on the market’s stellar return over the past ten years.
The return was indeed stellar, nearly 15% per year over the past ten years.
I’ve been around markets for a long time. Long enough to know that just when a trend looks well entrenched, it can change. And those changes can make you eat humble pie.
It is the reason regulators require a warning that past performance is not necessarily indicative of future performance.
The recommendation rests on two data points: the start and end of a particular ten-year period. But what about all the other ten-year periods over the past 100 years? And what does it say about the ten-year period starting today?
The fact that the S&P 500 returned well above its long-term average of about 10% a year over this ten-year period should probably also be considered. So should the circumstances that could have led to that outcome. One of the most revolutionary technologies rolled out when money was freely available in the wealthiest nation in history.
And if you examine other ten-year periods under similar circumstances, what you find can scare you. For example, the Japanese market outperformed all other stock markets through the end of 1989, returning about 20% per year in yen over the decade. It surpassed the US stock market to become the world’s largest market at the time. Over the subsequent decade, the Japanese stock market lost about half its value.
By this comparison, I am not saying that the US is about to see a decade of decline. I am pointing out that two data points cannot be extrapolated and used as sufficient information to make sound investment recommendations.
This conversation is missing the most basic understanding of statistics: the difference between one observation and a pattern. Something that happened between two data points is not a statistically repeatable pattern. It is not a reliable indicator of the future.
Even without knowledge of statistics, we could apply something else. Humility. Humility means understanding that my view of how the world works may be wrong, and that how it worked in the past may not be how it will work in the future.
In an investment portfolio, the practical expression of humility is diversification. It means including other equity markets, because they may be the winners over the next ten years. Even if they are not, they reduce the risk of being wrong.
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Kind regards,
Sunél
