Why past performance is a guide to future results

“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.

Harry Markowitz’s Modern Portfolio Theory (MPT), undoubtedly one of the most influential works in the history of finance, offers an interesting case in point. Originating 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 – through 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 after events a few years ago, is not necessarily the case in the real world.