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By Wealth Foundations

Asset prices quickly reflect everything we know

A fundamental tenet of our investment philosophy is that markets do a pretty good job in quickly incorporating information into asset prices. Current prices reflect a consensus of all past and current information. While these prices may not be “correct”, whatever that means, the robust academic research has revealed that it’s extremely difficult to reliably outperform the market consensus.

An implication for investors is that what we know now is likely to have little relevance for future investment returns, as this information is already incorporated in current prices of investment assets. It is only new, and, therefore, unknown, information that will lead to price changes.

But, for most, it is very hard to accept the notion that the vast majority of the information we are constantly bombarded with by the financial media and economic forecasters is virtually useless for making sound investment decisions. Being well informed about what’s happening now, or in the past, doesn’t give us a head start in predicting future investment returns.

Conventional investment wisdom proves exactly wrong

The past ten years (to 31 December 2014) provide a great illustration of the futility of making investment decisions based on what we know now. To aid the discussion, the table below shows the returns for major asset classes (using accepted benchmarks) broken down into two five year periods to 31 December 2009 and 31 December 2014

Let’s focus on the returns for the first five year period to 31 December 2009. Australian shares outperformed international shares and listed property by a considerable margin. In fact, at the time, listed property was widely regarded as an unmitigated disaster. Cash (proxied by bank bills) provided a reasonable and safe return, compared with more volatile bonds.

Also, remember the domestic and international economic environments that existed at the end of 2009. The US and European economies were struggling to recover from the Global Financial Crisis, providing little prospect for a quick return to previous profitability for international companies. While there had been some recovery since the low point of March 2009 in international share markets, they lagged well behind the Australian share market which was buoyed by the prospects for continued strong growth in China and demand for our resources.

In response to global recession, bond rates had fallen to their lowest levels in twenty years providing good returns to investors. But concerns regarding the need for increased government borrowings to finance budget deficits led many “experts” to suggest a “bond bubble” was forming.

The conventional investment “wisdom” at the end of 2009, for the next five years, was to stick with Australian shares, rather than international shares or listed property, in view of the known “China factor”. It was also to hold cash, rather than bonds, given it was regarded as inevitable, by many, that interest rates would soon rise imposing losses on bond holders.

Numerous articles also appeared in the financial media around this time citing the general outperformance of self managed super funds, with their concentrated holdings of Australian shares and cash (in the form of term deposits), compared with the more highly diversified industry and retail super funds. The implication was that the do-it-yourselfers were smarter than the professional fund managers.

But as the table above also reveals, knowing what we did at the end of 2009 and what had happened over the previous five years, provided no guidance to what investment returns actually did over the following five years to 31 December 2014.

What eventuated proved the opposite of the expectations that prevailed at end 2009. Australian shares were the growth asset laggard, while bonds did much better than cash. Listed property recovered strongly. With the benefit of hindsight, it’s easy to explain why the conventional wisdom proved so wrong – it always is. But that doesn’t mean we are any wiser now as to what returns will do next.

The “recency effect” is powerful, but unhelpful

As at end 2014, the conventional wisdom for the next five years is probably that international shares will continue to outperform a beleaguered Australian share market due to a soft AUD and weakening Australian economy, while there is now considered to be little danger of bond prices rising due to benign inflation. But as was the case at end 2009, this is simply an extrapolation of what we already know. It is what psychologists call the “recency effect” in action.

Our view is that in the unlikely event that this extrapolation proves correct it will almost certainly be due to events that are not currently contemplated. An antidote to the futility of attempting to predict investment returns is to diversify broadly across all the asset classes, consistent with your attitude and need for investment risk. The focus then is on managing your investment risk exposure rather than persisting with unproductive efforts to turn being well informed into valuable investment insights.

Wealth Foundations (ABN 95 965 896 114) is a corporate authorised representative of Wealth Leadership Services Pty Ltd (Corporate Authorised Representative No. 319641). Wealth Leadership Services Pty Limited (ABN 36 121 535 993) is a licensed Australian financial services firm (AFS Licence No. 317369).