By Tom Anderson / Guest Editorial

Nobody knows the future.

Investors, of course, wish they could see the future. A desire to know what the future has in store may explain why people pay so much attention to forecasts and commentaries. But a forecaster’s report is not a crystal ball. When it comes to the future, all we know is that we do not know.

I do not believe that anybody can predict the long term, and I particularly don’t believe that anybody can predict the short term. When economists have been asked which direction interest rates were going to go – up or down – they’ve been wrong about two-thirds of the time since 1982 according to Legg Mason and The Wall Street Journal Survey of Economists from Dec. 31, 2012.

So if forecasters’ reports cannot help us see the future, is there anything that can? Knowing financial history and having a solid understanding of basic math can help provide clarity. I will share these lessons from the liberal arts in this three-part series, along with some thoughts to keep investors grounded and disciplined.

First, two basic math facts:

1. If a position goes up 40 percent and then down 40 percent, you were better off being in cash. On the upside, an investment of $1 becomes $1.40. On the downside, that $1.40 returns $.84. That’s a net loss of 16 percent. The dollar bill wins the race.

2. In any given series, the starting value matters in determining total return. If an investment’s price moves from 100 to 300 to 100, a person who buys at 100 and sells at 200 makes a +100 percent return (or a +200 percent return if selling at the top). The maximum potential loss is zero. But what about the person who buys at 200? If Person Two sells at the top, the maximum profit is +50 percent. If he/she holds through the correction and sells at 100, the return is -50 percent. There’s a big difference between playing in the up 200 percent/down 0 percent world and trying to make it in the up 50 percent/down 50 percent world.

While these math facts may seem simple and straightforward, putting them in the context of financial history will provide perspective.

History lesson one: NASDAQ. The NASDAQ index hit 3,200 in late 1999 after trading around 1060 four years earlier. If you sold in 1999, you were up 200 percent, but missed out on an upward movement to 5,132. You may have been furious with yourself for becoming defensive too early. However, we now know that had you not sold at the top, you would have seen the NASDAQ fall to around 1,100 in October of 2002. (www.nasdaq.com historical quotes)

Interestingly as appealing as the NASDAQ and the technology sector looked 1996 to 2002, boring US treasury bills beat the return series of the NASDAQ. (www.treasury.gov and www.NASDAQ.com historical quotes)

History lesson two: Greece. If you paid attention to things like macroeconomics and valuation and got out of Greek equities in 2003, you missed out on a stunning series of double-digit returns through 2007, likely questioning your process (and your investment advisor) all along the way. In 2007, let’s say you decided to move back in with a nice portfolio of 60 percent Greek stocks and 40 percent Greek bonds. So what happened? Depending on your date of market entry, you could have faced a loss of roughly 60-90 percent on your equities through 2011 (www.bloomberg.com/quote/ASE:IND).

If you used the historic return series for Greek stocks of 2003-2007 to guide your perception of potential risk and return of Greek equities, you potentially made the exact opposite decision of what you should have made and decided to buy when you should have been selling. From 2003-2011, investors in a 60/40 Greek stock and bond portfolio could have lost over 50 percent of their capital. Holding cash would have been better.

History lesson three: Argentina. In hindsight, Argentina was one of the “easiest” crises to identify. As in our other examples, a string of positive returns from 1995-1997 preceded a steep decline through 2001.

I can continue these lessons with more examples from other countries including, of course, the United States. A study by the Federal Reserve (Federal Reserve Bank of St. Louis – Working Paper 2006-051A) shows that in the history of over 50 events in over 10 countries, significant busts have tended to follow significant booms throughout the past 100 years. In all of these scenarios, within one return series, investors could have had vastly different outcomes depending on when they were buying and when they were selling.

From these lessons, we can draw some conclusions that may stand the test of time (feel free to nominate any of these ideas for the next Nobel Prize):

  • It is better to buy low and sell high.
  • Assets that have gone up or down a lot may have different risk and return characteristics looking forward.
  • Sometimes process is rewarded, sometimes it is punished.

In my next piece, I will apply the lessons of history and math to the two asset classes that we get the most questions about: U.S. stocks and U.S. bonds. My third piece will provide ways investors may apply these lessons to a broad-based asset allocation process.

For more information, or if you’d like to see sources for all of my data, visit www.morganstanleyfa.com/theandersongroup and read my most recent commentary: “Perspectives – Fall 2013 – Clarity from the Liberal Arts: Lessons From History & Math – Part 1” found in the Anderson Group Economic Commentary.

 

NASDAQ Composite Index is a market-value-weighted index of all NASDAQ domestic and non-U.S. based common stocks listed on NASDAQ stock market. An investment cannot be made directly in a market index.

The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance does not guarantee future results.

 

Tom Anderson is an executive director – wealth management, senior portfolio management director, family wealth director and financial advisor with Morgan Stanley.

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