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Past Performance ≠ Future Returns

Learn from the past. Infer about the future. That’s life. If only that worked for investing, too! But past performance does not predict future returns.

Let’s start with ARKK.

ARKK (the Ark Innovation ETF) might be the most famous fund on Wall Street today. The fund invests in cool, modern tech companies – it’s chic and cutting-edge. It’s led by Ark CEO Cathie Wood – a whipsmart contrarian leader in an industry notoriously filled by men.

But above all else, ARKK is famous for its returns. Money makes a good story. Lots of money makes a great story. And from March 2020 through February 2021, ARKK returned a whopping 314%.

Since then? ARKK is down 52%. Ouch.

Why the whipsaw?

I see the clear fact that past performance does not equate to future returns.

There’s a reason why investments come with that disclaimer, and that’s what we’ll discuss today.

Dollar Weighted Average

ARKK was founded in October 2014. And despite ARKK’s terrible past 12 months, the fund is still up 272% from its 2014 founding.

Yet the average dollar invested in ARKK right now has lost money in the fund.

Huh? ARKK is 272% up, yet the average dollar within it is down? How?! Let’s break it down.

When ARKK was killing it in the market, few investors had their money in the fund.

Then came ARKK’s success, its headlines, and its fame. And then billions and billions more dollars poured into the fund. Investors who missed the big run wanted a piece of the action.

ARKK’s investments have since plummeted. The few early investors are happy (assuming they’re still invested). They’re up 200+%. But the many late investors are despondent—they’re down 50%.

If you average the few winners with the many losers, the average dollar in ARKK has lost money. Ouch. Despite all the glitz and glory and CNBC features, ARKK is full of losers.

Where did those investors go wrong?

One likely explanation: the late investors mistakenly expected ARKK’s future returns to mimic its past performance.

I love this quote from Joe Wiggins:

The more extreme the outperformance of a fund, the greater the likelihood of disappointing returns in the future. The more extreme the outperformance of a fund, the greater investor enthusiasm for it will be. That’s not a behaviour gap. It’s a chasm.

In other words: investors are doing the exact opposite of best practices. Outperformance drives their emotions up and drives future returns down. That’s a bad combo.

It’s funny how Cialdini’s law of social proof dominates so much of our lives. We wear certain clothes because we see others wearing them. We drive that car or play that sport because we see others doing the same. We follow the herd, with social proof providing the comfort that we’re normal.

But if we invest our money into an asset where many others have won, we might be shooting ourselves in the foot.

Why Did ARKK Fail to Retain Its Success?

Warren Buffett and Charlie Munger frequently describe the relative ease of running Berkshire Hathaway when it was small. It’s easy (comparatively) to find small investments with high upside. They routinely found million-dollar deals that tripled within a few short years.

It’s much harder to find billion-dollar deals that triple like that.

The bigger the pond, the greater the competition.

Similarly, ARKK’s early days were spent fishing in a small pond. By virtue of its own success, it found itself in an ever-growing pond. And when investor dollars kept pouring in, ARKK could no longer deploy those dollars in a meaningful way.

Past performance has the potential to curse itself. Hoisted by your own petard, as Shakespeare wrote.

The Simplified Mechanics of ARKK’s Investing Timeline

How did ARKK’s timeline unfold?

Imagine you’re at a public market. A man there is selling five-dollar bills for $3.00.

It’s not a scam. It’s just my weird hypothetical world. Do you buy them?

Of course, you do. You pay $60 and buy all 20 of the man’s five-dollar bills.

You return the next day. Now the man is selling five-dollar bills for $4.00. You pay $80 and buy all 20 of the man’s five-dollar bills.

On the third day, the man is selling them for $6.00. You pause. Why would you ever buy five-dollar bills for $6.00?

You wouldn’t. Of course you wouldn’t. With dollars, this exercise is silly and obvious. But what if you replaced the “five-dollar bills” with a stock?

You go to the stock market, and a man is selling Ford stock for $20. You buy it all.

He returns the next day with more Ford stock for $21. You buy it all.

$22, $23, $24…the price continues to rise as long as the demand is there.

The hard part with stocks is: how much is Ford actually worth? We know a five-dollar bill is worth $5.00. But what’s Ford’s intrinsic value?

With a stock, when do you know that you’re “buying a five-dollar bill for $6.00?” That’s a hard question. And if you knew the answer, you’d be a very wealthy person.

ARKK’s early days were filled with stocks selling far beneath their true value. They found five-dollar bills selling for $1.00. ARKK gobbled them up and turned a huge profit.

But as demand for ARKK grew, ARKK bought up the cheap deals until they weren’t cheap anymore. The five-dollar bills sold for $2, then $3, $4, $5. And eventually, for $6 or more.

Yet ARKK kept buying. In order to maintain the asset allocation of the fund, ARKK ended up buying stocks that (especially in hindsight) were incredibly overvalued. They were buying five-dollar bills for $10.

That’s practice isn’t sustainable. Given enough time, arithmetic always wins.

That’s why ARKK’s past 12 months have been abysmal. As the fund’s popularity grew, it cornered itself into buying overpriced stocks. And that’s a recipe for losing capital.

Past performance attracts more dollars. More dollars drive up the price. Higher prices lead to lower returns. Low returns repel dollars. Fewer dollars reduce the price. Lower prices lead to higher returns. The cycle continues.

Past Performance ≠ Future Returns.

Does This Apply to the Entire Market?

People frequently ask, “Is now a bad time to invest?”

If ARKK can topple from its once-lofty heights, couldn’t the same thing happen to the stock market as a whole?

To answer, let’s talk through a few ideas.

  1. ARKK is a sector fund, focusing on tech stocks and growth stocks. It’s not diversified. It’s not representative of the economy. The stock market (e.g. a Total Market Index Fund) however, is diversified and is representative of the economy. While it’s possible for the total market to be overbought, it’s less likely.
  2. In general, it’s hard to time the market. To say, “I’m going to avoid the entire stock market because it feels overbought (like ARKK),” is a timing statement. It’s hard to do well.
  3. Selling ARKK at it’s 2020 all-time highs looks smart in hindsight. Does that mean we should avoid the stock market when it’s at all-time highs? All historical data screams, “No! All-time highs happen all the time. Leaving your dollars on the sideline will only allow the market to run further and further away from you.

My Friends, The FI Couple

My good friends The FI Couple inspired this post after a Twitter conversation this week (you can listen to The FI Couple on Episode 35 of The Best Interest Podcast)

We debated: if the Schwab US Dividend Equity ETF ($SCHD) has returned an average of 17% per year over the past decade, should we assume future years will also return ~17% per year?

I think we’re on dangerous ground.

For example:

$SCHD was created in October 2011. It has returned 17% per year since. Over that same period, the entire stock market has averaged 16.3% per year returns. Roughly equivalent. You should ask yourself, “How different is $SCHD from the total market?”

Answer: $SCHD has a “beta” of 0.97—it’s highly correlated to the entire stock market.

$SCHD above, Total Market below. Notice any similarities?

This evidence all points in the same direction. Namely, that $SCHD is a reasonable proxy for the entire stock market (with a small tilt towards dividend stocks).

What’s my point?

If we think it’s reasonable for $SCHD to return 17% per year in posterity, then we should use that same logic to reach the same conclusion about the entire stock market.

17% per year.

And that’s bananas. I don’t know any investor (amateur, professional, whatever) who is assuming 17% annual stock market returns in their financial plans.

Past Performance ≠ Future Returns. Even if it’s a full decade of performance. That’s too short a timespan.

What About Over Long Time-Spans?

We’ve established that the past decade of stock performance shouldn’t be used as guidance for future return expectations.

Then why do so many “experts” discuss average returns in the stock market? If that average is from the past, why should we ever use it to plan the future?

Great question. I have a decent answer.

If we look at all 30-year periods in the stock market’s history, we see something…almost magical.

If a period starts hot, it ends cold. Other periods start cold, but end hot. Inevitably, long time periods have shown reversion to the mean. John Bogle believed that reversion to the mean is the single-most powerful force in investing.

actual stock market returns for 8 different 30 year periods

This chart shows the rolling annualized returns of the S&P 500 over various 30 year periods. The values are all adjusted for inflation (aka “real returns”).

For example, look at the red line – 1970-2000. By 1975 (Year 5), our investor is pretty sad. Their portfolio has averaged -9% per year. Ouch.

Up until 1982, returns are still bad. Sitting at Year 12, they’ve averaged -2% returns per year. 12 years is a long time. Our past 12 years have returned +306%. Their 12 years returned -14%.

But then an epic bull market began in 1982. By 1990 (Year 20), our investor was up around +5% per year returns (+153% total over 20 years). Not bad.

And by 2000 (Year 30), they’d achieved close to +8% per year for the entire 30 year period (+921% total over 30 years).

Start cold, end hot. Revert to the mean.

Go back to the chart. Check out the other periods. Whether hot or cold or in between, they all end up between +5% and +8% per year for the entire 30-year period.

Are the next 30 years guaranteed to follow this pattern? No way.

But is it reasonable to expect something “in family” with past results? I say yes.  

We might be in for some ugly returns in the future. That’s the nature of the stock market. Prepare now.

Whether you invest in ARKK, index funds, $SCHD, or something else…just remember that past performance ≠ future returns. Judging by your past actions, your future self will thank you. 😉

Thank you for reading! If you enjoyed this article, Subscribe to get future articles emailed to your inbox.

-Jesse

P.S. – If you enjoy podcasts, check out the Best Interest Podcast!

P.P.S – I wrote a book! Check out the ebook here and the physical Amazon book here.

4 thoughts on “Past Performance ≠ Future Returns”

  1. Honestly I am not surprised that the ARKK fund is down 50%. She’s been in the business for 30 years but the first time anyone had ever heard of her was after the pandemic when all her loss making stock picks surged, making the fund the best performer of 2020. I was impossible to sustain given the underlying valuations of stocks in the fund.

    1. Agreed Ryan, thanks for writing in!

      Outperformance is, by definition, hard to maintain long term. Reversion to the mean is bound to happen. Doesn’t mean that Cathie Wood did anything wrong. If anything, it’s more about investor psychology than anything else 🙂

  2. the time to buy something like ARKK is to start dollar cost averaging in now with a determined and consistent amount….after the 50% sell off. but the crowd are not wired that way. they are wired to chase winners once the trumpets are blaring on CNBC touting the outperformance. it’s good to diversify also and have a long time horizon. selling right now and locking in 50% losses doesn’t seem like a great idea. some of these companies will be the mastercards, coca colas, and apples of the future.

    1. Freddy! Good to see you here on The Best Interest, thanks for stopping by.

      Yeah – ARKK is a bit too concentrated for my blood, at any price. But maybe worth a small allocation?

      Agreed with everything you said regarding timing and DCA. If you’re going in, now would be a good time.

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