Understanding Returns
This article will help you define and distinguish realized returns from unrealized returns. By the end of this section, you will be able to calculate an investment's dollar return and percentage return. You will also be able to describe how to use historical and average returns to predict future performance.
Historical Returns: Market Variability and Volatility
LEARNING OBJECTIVE
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Describe how historical returns can be used to 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.
- animal spirits
After Keynes (citation 1936, above), the emotional and intuitive factors that drive business decisions whether to make investment gambles.
- volatility
A quantification of the degree of uncertainty about the future price of a commodity, share, or other financial product.
Historical analysis of markets and of specific securities is a useful tool for investors, but it does not predict the future of the market. 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 made the decision to invest because s/he would be guaranteed to make money was in for a shock when the market crashed in 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 them. These types of inter-linkages are a cause of the overall market variability and volatility.
Furthermore, market variability and volatility can be the cause of what John Maynard Keynes called animal spirits. Animal spirits are the emotions felt by investors who affect markets. Expectations of investors 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.