The financial market goes through different cycles. Historically, there are bull market cycles, where stocks tend to rally and bear cycles where they are usually in a downward trend.
For example, the market went through a bearish cycle in 2008 during the Global Financial Crisis (GFC) and a bullish one shortly afterward.
It is highly important for traders and investors to always know the state of the market cycle they are in. By doing so, they will have a good understanding of how to allocate resources and make money in the market.
So what is one of the best ways to analyze the markets and understand what cycle we are in? Analyze past performances. In this article, we will look at how past performances impacts future performance of an asset.
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Impact of past performances on future performance
A common mistake that many traders and investors make is to base their trading or investing criteria on the past performance. This means that people should avoid basing their decisions on what happened in the past.
For example, if a stock rallied by 50% this year, there is a likelihood that it will not do the same in the following year!
Also if an exchange-traded fund (ETF) has consistently provided excellent returns over the years, there is no guarantee that it will do the same in the future.
Another area where this applies is when selecting an investment manager or advisor. In most cases, you would want to use one who has consistently outperformed. But there is usually no guarantee that the manager will do well in the future.
Further, a company that has consistently done well over the years may not go through the same performance later.
Most importantly, a strategy that worked well in a certain market cycle will likely underperform when market conditions change.
For example, if the trend-following strategy worked well during a bull market, there is a likelihood that it will lag when the market moves into a narrow range.
Related » Trader’s Superpower: Adaptability
Importance of past performances
While historical performance is not an indicator of what to happen, it can help you a great deal in many ways.
Good track record
First, when selecting a trading strategy, you want one that has a good track record of doing well in the past. This explains why many people stick to their trading strategies that have consistently done well in the past. Although not 100%perfect, it is enough that this strategy generates more gains than your losses.
And it is also the same reason why some traders fall in love with a stock! They have brought them a lot of profits, so they keep beating that path. Needless to say, the risks of this approach are many.
Backtesting
Second, you should use past performances when backtesting a strategy. Backtesting is a process where you place a strategy in several tests using historical data.
The goal is to see the performance of the strategy or the robot. Checking this will then help you determine whether the strategy will work later.
Backtesting should always be accompanied by forward testing, where you use live data in a demo account. Forward testing will help you see whether the strategy works well in the real market.
Building your team
Third, past performance can also help you when hiring a trader or an investment professional. For example, when running a hedge fund or a trading floor, you simply want to have someone who is really good.
In this situation, given a choice between a high-performing trader and an inexperienced one, you should select the former. The idea is that the trader will reciprocate the performance in the future.
Further, you should check the historical performances of the analysts you follow. Some sell-side analysts are known for being highly accurate while others are known for making the wrong predictions.
Correlation
Last but not least, you can use the historical performance of a company to predict the future of a firm in the same industry. For example, if a company like JP Morgan publishes strong results, you can use this data to predict how other banks will perform.
Related » The Benefits of Correlation in Day Trading
Therefore, while past performance is not an indicator for what to expect in the future, historical data is an important part of the market.
Using the Sharpe ratio in the market
One way of predicting the future performance of an asset is to use the Sharpe ratio, which was developed by William Sharpe. The goal of this ratio is to get the risk-adjusted return of an asset. It is calculated using the following formula:
Sharpe ratio = (Average Returns of an Investment – Returns of a Risk-free Investment) / Standard Deviation
In this case, the average return is what you expect in the future while the risk-free investment mostly focuses on government or high-grade bonds. The standard deviation refers to the risk involved with an investment.
A good example is: assume that you expect to earn a 15% return by investing in company A that has averaged 15% annually. Also, assume that government bonds have an interest rate of 0.4 and the standard deviation 20%. Therefore, in this case, the calculation is (15% – 0.3%) /20% = 0.73.
The perils of using past performances
There are several reasons why past performance is not a good indicator of future performance. First, in some cases, past performance could be luck. For example, maybe a trader had a strong performance in the past because they were just lucky.
Second, using historical data ignores some important details like the prevailing interest rates, wars, and other macro factors.
For example, the stock market jumped after the Global Financial Crisis (GFC) of 2008 because interest rates moved to zero. The same explains why stocks jumped during the Covid-19 pandemic.
Third, past performance in stocks could exclude the fundamentals of a company. For example, it does not foresee a potential acquisition or management change.
Also, it does not include new competition in the industry and change of sentiment in the market. For example, there was a time when smoking was cool and today it is not.
Summary
It is often said that the past performance is not an indication of what to expect in the future. This is true. However, it is always important to use history when investing or trading.
You can use it when backtesting a robot or a strategy, when selecting an investment advisor, and when analyzing a company.
External useful resource
- Past Performance Is Not Indicative Of Future Results – Forbes
