Keep your eyes on the road ahead

Chartists do it. Some financial planners do it. Economists do it. Let’s face it, even some research houses do it.

Using past performance to predict future investment returns is a practice that has been widespread in the investment community for years.

But according to Tim Farrelly, a speaker at this year’s FPA Convention, anyone who does it is making a big mistake.

“The rear view mirror is broken,” according to Farrelly, who is a firm believer that looking backwards is no way for anyone to make asset allocation decisions for their clients.

“Chasing past returns is dumb. People try and think it’s a challenge, but it’s worse than dumb, it is dangerous and it actually gets you to do the wrong thing most of the time,” says Farrelly, who is a past Macquarie Bank executive director, principal of his own investment consulting group — Farrelly’s, and a visiting fellow at the school of finance and economics at the University of Technology, Sydney.

But if it’s so dumb, why do people keep on doing it?

“There are a lot of academics and fund managers who subscribe to the idea that markets are kind of efficient, so if markets are kind of efficient, then the returns that you get out of any market should be reasonably consistent over a long period of time. Therefore, you should be able to look to history and say historically if the returns have been that, then it’s reasonable to assume that the returns are going to look like that in the future.”

Farrelly says nothing could be further from the truth.

“If you use the last 20 years of returns data to forecast going ahead, you’d be pretty specifically going in the opposite direction you should be going and the reasons why that should be the case are actually fairly predictable as well.”

A good example of what Farrelly is talking about occurred a few years ago when a host of Australian investors bought into international equities, which up until 1999 had a brilliant track record.

But if they had done their sums, Farrelly says advisers and their clients could have predicted the sudden downturn in what used to be the darling of most Australians’ investment portfolios.

Farrelly says there is a much better — and surprisingly simple — methodology for predicting future investment performance where advisers can offer sensible long-term forecasts without having to make too many dramatic assumptions.

That methodology basically involves keeping a close eye on valuations, chiefly by considering price earnings (PE) ratios.

To illustrate, pretend it is 1999. US equities had dividend yields of about 1 per cent. Assuming that company earnings growth would manage to keep up with gross domestic product (GDP), investors could expect earnings growth of about 3.5 per cent (although Farrelly adds this is a optimistic prediction). Add to that 2.5 per cent inflation and in 1999 an investor in international equities could be predicting returns of about 7 per cent. At the time, though, PE ratios were remarkably inflated at about 30.

According to Farrelly, a reduction of PEs of only 10 points would have been enough to wipe off about 4 per cent off those returns.

And that’s exactly what happened. PEs for international equities dropped to 20 and investors ended up with returns of 2 to 3 per cent.

“That’s not a complicated analysis,” says Farrelly who, using the above methodology, successfully predicted that listed property trusts were the place to be back in 1999.

Looking forward, Farrelly says that valuations are now at a much more reasonable level, except for residential property, where he says valuations are ‘way out of whack’.

Tim Farrelly’s session, ‘The Rear View Mirror is Broken: What Do You Do Now?’ is on Thursday December 2 at 11:55am-12:55pm.