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Clinging to the past

“Past performance is not a guide to future performance” might just be the most frequently quoted mantra in the world of investment.

As the sine qua non of any compliance department’s output, this starkest of warnings – or some approximation thereof – adorns virtually every shred of client-facing literature and marketing collateral. Most investors will have subconsciously digested it countless times while scanning their annual updates, visiting websites, agreeing to terms or leafing through brochures announcing the launch of this fund or that product.

And yet how many of them actually believe it? The question might sound frivolous, but in truth it is of enormous importance. Amid continuing financial turmoil and with many major economies facing potentially monumental challenges, this is an issue that is well worth addressing as part of the wider and increasingly crucial debate concerning the role of consumer rationality.

The events of recent years, of course, have cast growing doubt on the wisdom of a financial system based on a seemingly unshakeable faith in economic rationality. Such an approach has dominated for decades, but the chaos of the 2008 crisis, together with much of what has followed, has highlighted the urgent need to pay more attention to what we might generally regard as “human” factors.

Markowitz’s Modern Portfolio Theory (MPT), undoubtedly one of the most influential works in the history of finance, offers an interesting case in point for our purposes. Originated in the 1950s and developed until the 1970s, when the concept of economic rationality was arguably at its undisputed peak, it established a number of precepts that to this day are still adhered to by many fund managers. In basic terms, MPT seeks to maximise a portfolio’s expected return for a certain amount of risk – or to minimise risk for a certain amount of return – via the careful selection of various assets. The idea is that successful diversification leads to an array of investments whose risk collectively is lower than that of any component asset individually.

Various criticisms have been levelled at MPT over time. These include that it sometimes demands the embracing of what is perceived to be a risky investment – futures, for instance – to reduce overall risk; that it assumes it is feasible to choose stocks whose performance is independent of other investments, which, according to a wealth of research, is effectively impossible in times of market stress; and that it supposes the existence of risk-free investments, an idea that appears particularly fanciful in the current climate.

All things considered, perhaps MPT’s most fundamental flaw is that, like a good number of the theories that have largely guided economics since the 1950s, it presumes markets are efficient and investors are rational. This, as we all now appreciate a little more than a few years ago, is not necessarily the case in the “real world”.

At the heart of MPT is the relationship between volatility – or risk – and returns. Standard deviation, which analyses the historical variability of returns from their mean, has been a classical measure of portfolio risk since Markovitz used it to demonstrate risk reduction through diversification. The higher the standard deviation from the mean, says Markowitz, the greater the risk associated with the investment and thus the higher the return of the investment.

Cynics might point out at this juncture that – to quote the mantra yet again – past performance is not a guide to future performance and it is therefore rather ironic, to put it mildly, that a methodology apparently in contradiction of this view has come to underpin much of the financial system. For the moment we shall politely ignore this paradox in favour of focusing on the importance of rationality or, indeed, its absence.

China’s stock market provides a fascinating insight in terms of assessing the robustness of the much-vaunted relationship between volatility and returns. The reason for this is that, as an emerging market, it possesses characteristics that are not to be found in its mature and well-developed counterparts. It has fewer institutional investors, more volatility and less rational investment behaviour.

The last of these attributes has been the subject of revealing research. A 2011 University of Nottingham study, for instance, concluded a key contributor to the Chinese stock market bubble that started in 2005 was the poor and irrational psychology of the nation’s investors and that greed, envy and speculation were crucial drivers of a catastrophe that ultimately shattered the dreams of millions of ordinary Chinese. The Shanghai and Shenzen Exchanges were opened only in the early 1990s, remember, and many domestic investors had little knowledge about the markets’ capacity to fall as well as rise.

This all-too-human irrationality was again highlighted when academics from Nottingham University Business School in Ningbo, China, used data from the China Stock Market and Accounting Research Database to study the relationship between volatility and returns on the Chinese stock market from 1991 to 2008. The relationships observed were consistent with herding instinct and extrapolation bias, two phenomena that have been the subject of considerable work in the field of behavioural economics.

Herding instinct is common to large stock market trends that commence and climax with periods of frenetic buying or selling. As per the Chinese stock market bubble mentioned above or, more famously in the UK, the run on Northern Rock, these periods are characterised by intense emotions. In the rush to enter or exit the market, as the extreme somehow becomes the norm, rationality is swept aside by the likes of avarice, panic and fear.

Extrapolation bias, meanwhile, is the term applied to our tendency to judge the past and the present in estimating the future. All seems positive when the market is rising; all appears hopeless when the market is falling. The result is that we under-react or overreact. In other words, as far as the average investor is concerned, past performance is a guide to future performance. No matter how many times you read it in the small print, you cannot quite accept the well-worn caution to the contrary – and why should you, given that the rigorous examination of historical information is an intrinsic element of the way the investment world functions? We are only human, after all.

And there’s the rub. Compliance departments may be honour-bound to insist otherwise – and understandably so – but none of us is a perfect machine. As we once again edge closer to the abyss, the very least we can do is learn from our mistakes, one of which has been a far too rigid devotion to economic theories that prize mathematical sophistication over reality and reason. How the sphere of finance and investment at last comprehensively shrugs off this long-held misconception remains to be seen, but this much is certain: it cannot happen soon enough.

Xiao Gang Bi is an Assistant Professor of Finance at Nottingham University Business School, based at the University of Nottingham, Ningbo, China (UNNC), where he is also a Research Fellow with the Globalisation and Economic Policy Centre (GEP). This article is based on research carried out with Dr Qing-Ping Ma, also of UNNC.

Posted on Thursday 9th February 2012

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