In his recent essay titled – Five Things I Know about Investing, Kenneth French explains why chance dominates realized returns. Here’s an excerpt from the essay:
Perhaps because the evolutionary cost of false negatives – failing to see real patterns – was high relative to the cost of false positives, people seem hardwired to identify patterns, whether they are real or not (e.g., Shermer 2008). Who hasn’t seen a ship in the clouds or human figures in a dirty window?
Those of us who grew up in New Hampshire in the 20th century have fond memories of the Old Man of the Mountain, a rock formation that looked like the silhouette of, well, an old man. We mourned when he fell from the mountain in 2003 and are proud to honor his memory on our road signs and license plates.
Given the importance of financial markets and the human inclination to identify patterns, it is not surprising that researchers and investors have found patterns in asset prices and returns for centuries and continue to do so now. It is also not surprising that a nontrivial fraction of the patterns are false positives.
We can split an asset’s return into its expected return, which is our best guess of what will happen based on all the information currently available, and its unexpected return, which is the surprise – the difference between what actually does happen and what was expected,
R = E(R) + U. (1)
The goal of most who study stock returns is to predict the future, not describe the past. In the context of equation (1), researchers are trying to identify persistent differences in expected return across assets or asset classes.
Differences in the cross-section of expected returns, however, are usually small relative to the volatility of unexpected returns, so realized returns are mostly the result of chance. Over reasonable investment horizons – three, five, ten, even 20 years – realized returns are typically dominated by the unexpected component and inferences from realized returns are often false positives.
The performance of FAANG stocks – Facebook, Amazon, Apple, Netflix, and Google – over the decade from 2012 to 2021 illustrates the importance of unexpected returns. (I know, some of the names have changed, but FAANG sounds better than MAANA.) The 2012-2021 average annual return on a VW portfolio of these five large stocks is 30.09% and the cumulative ten-year return is 1166%.
(The FAANG portfolio and value-weight market returns here and below are computed using monthly data from Chicago Booth’s Center for Research in Security Prices, CRSP, and are denominated in US dollars.) Should we expect the portfolio to deliver 1166% over the next decade? No. Strong unexpected returns are a better explanation for the great return and, by definition, the expected value of future unexpected returns must be zero.
Those who use the recent returns on the FAANG portfolio to predict its future returns will probably be disappointed.
You can read the entire essay here:
Kenneth French – Five Things I Know about Investing
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