Be wary of extrapolating the recent past into the future
‘Study the past, if you would divine the future’ — Confucius.
A quick study of the recent past shows us all is steady on markets. Dow up a little. Gold had a US$7 bounce. Trump continues to pepper his feet with bullets. The Clintons continue to take money from any hustler with a wad of cash. The world is as it should be. The establishment has it all under control…or at least they think so.
While markets remain in this period of relative calm, we can indulge in a little reflective thinking.
Do you know what the biggest mistake 90% of investors make is?
Projecting past performance and trends into the future.
The numerous studies on monies into, and out of, managed funds found a predictable pattern. A flood of dollars pours in at the top of a market and flows out at the bottom.
If markets have been bad, they’ll stay bad. On the other hand, if markets are on the up and up, this trend is forecast to continue…even though markets are becoming more and more overvalued.
Our frames of reference tend to be confined to recent experiences.
The thinking is: ‘What has been will continue to be’.
Yet, the history of both human progress and investment markets tells us this thinking is flawed.
Over a century ago, the world’s major cities had a very serious public health problem:
‘In 1898, delegates from across the globe gathered in New York City for the world’s first international urban planning conference. One topic dominated the discussion. It was not housing, land use, economic development, or infrastructure. The delegates were driven to desperation by horse manure.’
— From Horse Power to Horsepower, by Eric Morris
While this seems funny today, back then, mounting piles of horse manure was anything but a laughing matter.
For centuries, horses were the mode of transport. As populations grew, so did the number of horses — and the piles of manure…
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The problem the city’s fathers faced in the late 1800s was not new. In Ancient Rome, Julius Caesar banned horse-drawn carts between dawn and dusk.
Between 1800 and 1900, the US population expanded by 30 million. More people meant more trade, which, in turn, meant more horses.
The railway did relieve some of the horse-drawn transportation issues. However, within the towns and cities, goods were still delivered by the traditional horse and cart.
The first public transport system in New York was the Omnibus (carrying up to 120,000 passengers per day). A bus pulled by a team of horses. If the public commute was not to your liking, personal transportation was still by horse-drawn carriage.
In the wide open spaces of Wyoming, the increase in horse numbers was not a problem. There was plenty of space for natural fertiliser out there. However, in densely populated areas like New York, it was a whole different matter.
In New York, it was estimated that, on a daily basis, there was 1.8 million kilos of horse dung and 150,000 litres of equine urine to be ‘handled’.
Naturally, all this horse waste became a pedestrian nightmare — especially when it rained. In addition to the obvious issue of dodging the ‘land mines,’ there were serious health issues confronting the city administrators.
There is nothing like a dung pile to attract flies. The spread of typhoid and diarrhoea (especially among infants) increased mortality rates.
With this brief background, you can see why the 1898 urban planning conference had horse manure as the most pressing topic on its agenda. Apparently the meeting was scheduled to last for 10 days. After three days the meeting was terminated, as no acceptable solution to the problem could be found.
The issues associated with too many horses had plagued Rome nearly 2,000 years ago and was such a long established trend that the world’s town planners resigned themselves to it being an unsolvable problem.
According to Eric Morris:
‘The situation seemed dire. In 1894, the ‘Times’ of London estimated that by 1950 every street in the city would be buried nine feet deep in horse manure. One New York prognosticator of the 1890s concluded that by 1930 the horse droppings would rise to Manhattan’s third-story windows. A public health and sanitation crisis of almost unimaginable dimensions loomed.’
Based on the knowledge at the time — population growth and volumes of horse waste — you can appreciate the math behind the forecast of ‘pavements of poop’ piled up to the third floor.
These days, the only horse poop in New York is around Central Park, where horse and carriage rides await to take love-struck and nostalgic tourists on an overpriced ride through the park.
The ‘piles of poop‘ forecast is known as ‘extrapolation’ — taking an established trend and projecting it into the future. The problem with extrapolation is that an unforeseen disruptor can change the trend, making forecasts look silly to future generations.
In the case of mounting horse poop as a trend, we know the advent of the combustion engine didn’t just change the trend, it killed it.
For example, in the late 1800s — based on the forecast trend of sky high ‘piles of poop’ — you are given an investment opportunity to buy shares in a business that has the monopoly on clearing New York streets of horse dung and selling on the muck as fertiliser. It’s likely the words ‘you can’t go wrong with this investment’ come to mind.
Not only would the ‘poop collection’ business have eventually failed, the fertiliser business would also have run into trouble (according to Eric Morris’s paper):
‘Manure makes fine fertilizer, and an active manure trade existed in the nineteenth-century city. However, as the century wore on the surge in the number of horses caused the bottom to fall out of this market; while early in the century farmers were happy to pay good money for the manure, by the end of the 1800s stable owners had to pay to have it carted off.’
The risk with extrapolation is that you are projecting forward an indefinite continuation of a trend. In reality, the only definite trend we can completely rely upon is the sun rising in the east and setting in the west.
We all know ‘change is the only constant in life’, yet, when it comes to investing, we expect recent past performance (good or bad) to be replicated in the future.
Which is why the final phase of a boom is ‘white hot’ with excitement. The crowd is piling in on an established and (what has been) profitable trend…believing the returns of the past will be theirs in the future. Big mistake.
Studying the past to divine the future is a luxury most people do not have. The pressures of day to day living get in the way.
To be a successful investor, you need time to think, to access people with knowledge, to be patient, to be in a position to capitalise, to appreciate and understand trends and herd behaviour.
The investment industry does not foster this approach. The primary motivation is funds under management. Remaining in cash, waiting for a booming trend to reverse, is in conflict with the industry’s agenda.
The trend the industry promotes is ‘shares always go up in the long term’. True, but the vast majority of investors do not have the 50 to 100-year investment timeframes this trend is based on.
Most investors — with significant levels of capital — have 20 to 30 years. A study of market history shows there are a 20-plus-year periods when share markets perform badly. In fact, the All Ordinaries Index is currently at a level it first reached a decade ago.
The industry rarely, if ever, says ‘Hey, this is not a good time to invest because the herd is going nuts and you’ll be better off staying in cash.’
No one cares for your money like you do. You know what it’s taken to accumulate your money. The long hours. The sacrifices. You need to take control of your money…especially at a time when there are so many signs of danger ahead.
Do not extrapolate the recent past into the future.
Central banks are receiving almost weekly warnings that the stimulus actions of the past cannot continue. European banks are struggling.
Think a little more deeply about what’s happening…it’s in your best interests to do so.
There’s plenty of evidence of the trends in play for you to make considered decisions.
Successfully navigating the social, economic, business and financial challenges of the next five to 10 years, in my opinion, is going to be the biggest collective make or break of wealth since the Great Depression.
Fortunes will be made or lost.
In the weekend edition of Markets and Money, this coming Saturday, we’ll take a look at some of the trends that are likely to shape our future.
For Markets and Money