Trying to guess the future

Posted: December 22, 2009

Stellar performance is sometimes followed by a stellar fall. For instance, Australian shares produced returns between 14% and 28% in the years 2003 to 2007 followed by a drop of 38% in 2008. Listed property trusts crashed by 54% in 2008 after averaging returns of 18.8% between 2000 and 2006.

Over the last twenty years, international shares have been the best performer in six years but also the worst in four years. Cash produced the lowest return nearly half the time but was the best asset class in 1994. 

The crystal ball

What if you could predict the future and know what asset class would be the best performer each year? You start with $10,000 in 1989 and invest in international shares. With a return of 24.2% by the end of the year you have $12,420. You cash it in and invest in Australian bonds in 1990 and earn 19.1%. Ignoring taxes, after 20 years your $10,000 will have grown to $489,480.

The follower

Unfortunately no-one knows for certain which asset class will perform the best each year. One approach would be to invest in the previous year's best performing asset class. Sometimes this works well such as in the late 1990's when international shares reeled off three years of returns of over 20%. 

But in many instances being a follower doesn't work. Between 2000 and 2008 a different asset class was the top performer so picking last year's winner was not the best strategy in that period. If you had invested $10,000 in 1989 and used the follower strategy you would have accumulated $26,683 after twenty years.

The contrarian

A different approach is to use the idea that a different asset class will be the best performer every year. You do the opposite to the follower strategy and invest in last year's worst performer in the expectation that you will catch assets as they recover. 

Again this strategy sometimes works. In 1992 and 1994 Australian shares posted negative returns but returned 45.4% in 1993 and 20.2% in 1995. If you had invested $10,000 in 1989 and used the contrarian strategy you would have accumulated $43,132 after nineteen years. Sadly by investing in listed property trusts in 2008, you went backwards and ended up with $19,841.

Figure 1 Investment returns for years ending 31 December

But investment markets are fickle in the short term. What if you put off investing your $10,000 from 1 January 1989 until June 1989? Applying the three strategies over the next twenty years to June 2009 gives quite different results. The crystal ball strategy produced an outcome of $419,664, the follower strategy $100,015 and the contrarian $32,585.

Figure 2 Investment returns for years ending 30 June 

The moral

No-one has a crystal ball so the blue line is unachievable. The analysis shows that neither the follower nor the contrarian system works consistently. One may work over the short term but you will only know whether it was successful in hindsight. You are more likely to get a consistent result by employing a disciplined strategy where asset selection is driven by research and analysis.