History — An imperfect guide to the future

Posted by on December 19, 2011 @ 12:59 pm in investing

There’s a good reason why regulators require financial firms to include, when mentioning the past returns or ratings of a mutual fund, the warning: “Past performance is not a guarantee of future results.”

The warning is true. History is an imperfect guide to the future, or historians would be fabulously wealthy investment sages.
But history does seem, if not to repeat, to rhyme from time to time.

An example came my way from a colleague who was looking at the 1974 annual report of Vanguard’s predecessor firm, Wellington Management Co.

Some of the observations in the report were eerily similar to commentary about recent events. For example:

“A very difficult year is now behind us. Economically, politically, and socially, it seemed interminable. It was a year that tested everybody.”

And this: “Unstable governments were toppled, inadequate leaders were replaced, and respected countries bordered on bankruptcy.”

And, finally, this: “Uncertainty rose and confidence eroded. Nowhere was this erosion in confidence more vivid than in the securities markets.”

The stock market lost nearly 30% in 1974, after having dropped more than 15% in 1973. Bonds also produced negative returns in 1974.

Of course, markets had plenty to be gloomy about in 1974:

• The impeachment and resignation of a president.
• The bloody Vietnam War was headed toward a very messy end.
• Unemployment was rising (though the average jobless rate of 5.6% was well below today’s rate).
• We were in the midst of a deep recession at the same time inflation was running at a double-digit rate.

In one sense, it would be nice if history rhymed again: Financial markets produced fat returns in 1975, with stocks returning more than 38% and bonds producing returns of about 15%.

However, it would be virtually impossible for bonds to produce such a high return from a starting point of today’s extremely low yields. And stock market valuations were much lower in 1974, with dividend and earnings yields far higher than today’s levels.

Even so, the old Wellington report is a reminder that American investors have faced tough economic and market conditions before and managed through them.

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