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Beware the Graph

There’s a question I hear on a regular basis from clients that I find both easy to answer and hard to explain: “So, what’s the past history of this fund?”

It’s an easy answer because it’s a number that can easily be looked up but the reason we ask it is that we are looking for reassurance that we can predict the future of this investment; the reason it’s a bad question is that the answer does not give this reassurance.

If you flip a coin and it comes up heads, what are the odds it will come up heads again on the next flip? 50%. Does the fact that it just came up heads have any effect on this next flip? No.

And the problem is that the conditions change every time. If you could 100% replicate the force of your thumb on the coin, the air forces acting on the coin, the angle of the coin when struck and caught, etc., I’m sure you could actually predict the coin’s result. But everyone who has ever flipped a coin knows that this is impossible.

With the markets, the variables are even more diverse. Interest rates, government agendas, day-traders, economic conditions across the globe, various investors, company board members, all the way down to the end consumer – there are just way too many players on the board.

There are a few mathematical rules that seem to work out on average though. Risk is usually rewarded with a higher return. If you give an investment enough time you can make money. If you think first and act second, you can have a good investment experience.

And this is how the market is different from gambling – or flipping a coin. There are rules; we just seem to forget them from time to time. But the ‘rule’ of the 5 year history being an indicator of the next few years’ experience – not a rule, more of a guideline.