Understanding Returns
Historical Returns: Market Variability and Volatility
Markets and securities may follow general trends, but exogenous factors (such as macroeconomic changes) cause variability and volatility.
Historical analysis of markets and specific securities is a useful tool for investors, but it does not predict the market's future. There are general trends
and expectations of future behavior, but they are just generalizations.
For example, the Dow Jones Industrial Average (DJIA) has generally
followed an upward trend from 1900-2009. However, an investor who
looked at this graph in early 1929 and decided to invest
because s/he would be guaranteed to make money was in for a shock when
the market crashed on October 29, 1929. Past performance is not a
guarantee of future performance.
DJIA 1900-2009 The Dow Jones Industrial Average has generally increased overall since 1900, but its past performance is not a guarantee of future performance.
Inherent in all markets is something called "systemic risk." Systemic risk is the risk of collapse of an entire financial system
or entire market, as opposed to risk associated with any one individual
entity, group, or component of a system. Macroeconomic forces, such as
the Great Depression, affect the entire stock
market and can't be predicted from past market performance. The failure
of one company affects all the companies who purchase from it or sell
to it, which in turn affects all the companies that rely on it. These
types of interlinkages cause overall market variability and
volatility.
Furthermore, market variability and volatility can cause what John Maynard Keynes called animal spirits. Animal spirits are the emotions felt by investors who affect markets. Investors' expectations affect how they act, which in turn affects the markets. If investors are feeling optimistic, for example, the market may go up, even without an improvement in the financials of the underlying companies.
Markets and stocks are affected by many factors beyond the information in their financial statements and past performance. Historical returns may provide an idea of the overall trend but certainly are not enough to accurately predict future performance.
Key Points
- Historical returns do not guarantee future returns.
- All markets have a degree of systemic risk
which means that they have a risk of collapsing due to external
factors. Companies are also interconnected, so the failure of one
company can have far-reaching effects.
- "Animal spirits" describes general investor sentiment which can affect markets, even without changes in the underlying financials.
Terms
- Systemic Risk – the risk of collapse of an entire financial system or entire market.
- Volatility – a quantification of the degree of uncertainty about the future price of a commodity, share, or other financial product.
- Animal Spirits – after Keynes (citation 1936, above), the emotional and intuitive factors that drive business decisions whether to make investment gambles.