“Past performance does not guarantee future results.”
This piece of advice warns against the dangers of expecting previous trends to continue.
When we are picking stocks and other investments, we tend to focus on their past performances. Has the price been steadily increasing? Is there a clear upward trend on the chart?
Unfortunately, many retail investors will only look at the trend. In other words, they will look at the recent price action instead of doing any meaningful due diligence.
I mean, why spend hours researching a company when you can just look at the 5-year chart?
“It’s been going up for the past 2 years? I’ll have 50 shares. Thank you very much. *click*”
The problem with this “strategy” is that all trends end.
The trend is your friend, until it isn’t.
Basically, “the trend is your friend” until it suddenly decides to leave you on some random Thursday afternoon.
An investment that has provided excellent returns for the past six years may suddenly plateau or fall. A trading setup that has been hugely successful can blow your account out of the water if you do not have proper risk management in place.
An example of how past performance does not guarantee future results.
In March 2020, COVID-19 became a serious issue. As a result, the stock market started to crash. Prices were tumbling downward and there didn’t seem to be a bottom in sight.
During this turmoil, a number of traders continued to buy “put options”. These put options were essentially a bet against the market.
As the market continued to drop, these traders continued to make a lot of money.
Unfortunately, a lot of these traders became greedy. Betting against the market during a crash felt like an easy way to make money. As a result, they kept buying put options.
Buy a put option, wait for the market to fall even further and then sell that option for a profit. Rinse and repeat.
The market hits its bottom.
Then, on March 23rd, the market hit its bottom.
However, at the time, nobody knew that this was the bottom. In fact, most people expected the market to fall even further. Consequently, many of these traders continued to buy put options.
When a trend finally comes to an end, there is no special announcement. Nobody comes out to ring a bell and proclaim that a new era has begun.
By the time these traders realized that the crash was over, they had already given back most of their earlier gains.
In other words, as the market rebounded, their put options started to lose money. However, many of them continued to double down. “This is just a temporary bounce”, they told themselves. “This crash is far from over.”
As we now know, the crash was over. We just didn’t know it at the time.
In this case, these traders allowed the past performance of the market to influence their decisions. In hindsight, they probably should have “cooled off” for a while before continuing with this strategy.
History is full of examples of how the past performance of an investment does not guarantee future results. In many of these cases, investors fooled themselves into thinking that the trend would continue for years to come.
From the mid-1990s onward, investors began to speculate on Internet companies. This is despite the fact that many of them weren’t even turning a profit.
Many of these investors did not care about valuations or balance sheets. They cared about the trend.
It was simple. Buy shares in a dot-com company and the price would go up.
Unfortunately, this worked until it no longer worked. In other words, the bubble burst and a lot of these Internet companies went out of business.
Furthermore, the companies that did manage to survive took a huge hit. For example, Amazon’s share price fell by 90%.
Irish property bubble.
This rule doesn’t just apply to stocks.
In the early 2000s, Irish property prices started to rise. By the mid-2000s, the Celtic Tiger was in full swing and “investors” were speculating on housing.
The Irish media and financial advisors were also “hyping up” property as an easy way to make money.
During this period, house prices continued to climb. So much so, in fact, that people were taking out second mortgages to get in on the action.
“Prices are only going to keep rising”, was a common piece of advice at the time.
To make a long story short, it all came to a shuddering halt in 2008.
The demand for residential properties fell and construction companies around the country went bankrupt. By the end of 2010, over 30% of mortgages were in negative equity.
To make matters even worse, Ireland’s banking sector nearly collapsed.
All trends eventually come to an end.
A trend can last for years and years. It can last for so long that people begin to forget what it was like before the trend started.
At this stage, investors begin to feel as if it is a sure thing. That it’s an easy way to print money.
On the flip side of the coin, you will find people predicting that a trend is ending long before it actually does. For example, over the years, there have been a number of failed predictions about when the stock market is going to crash.
The problem with trends is that nobody really knows how long they will last. This is why buying stocks with the intention of holding them over a long-term period is often the best strategy for “beating the market”.
However, as we have seen with Japan’s 30-year-long stock market plateau, even that strategy isn’t a sure thing.