Can You See the Future?

A key excerpt from Andrew Ang’s book Asset Management: A Systematic Approach to Factor Investing:

Investors must use past data to estimate inputs for optimization problems.  But many investors simply take historical averages on short, rolling samples.  This is the worst thing you can do.

In drawing all of the mean-variance frontiers for the G5, or various subsets of countries, I used historical data.  I plead guilty.  I did, however, use a fairly long sample, from January 1970 to December 2011.  Nevertheless, even this approximately forty-year sample is relatively short.  You should view the figures in this chapter as what has transpired over the last forty years and not as pictures of what will happen in the future.  As the investment companies like to say in small print, past performance is no guarantee of future returns.  The inputs required for mean-variance investing—expected returns, volatilities, and correlations—are statements about what we think will happen in the future.

Using short data samples to produce estimates for mean-variance inputs is very dangerous.  It leads to pro-cyclicality.  When past returns have been high, current prices are high.  But current prices are high because future returns tend to be low.  Thus, using a past data sample to estimate a mean produces a high estimate right when future returns are likely to be low.  These problems are compounded when more recent data are weighted more heavily, which occurs in techniques like exponential smoothing.

Mean-variance optimization (a darling of financial theory) works just fine when you can accurately predict returns, volatilities, and correlations.  But, if you can’t (or should I say when you can’t), mean-variance optimization is useless.  As Ang points out, simply taking historical averages “is the worst thing you can do.”  Alas, coming up with the optimal asset allocation that will allow us to create wonderful returns with a small amount of volatility is comforting to wish for, but real life is much messier than the theory.

Trend following may, admittedly,  be somewhat simple (although as John can attest, the computer programming required isn’t for simpletons).  But, the only question that ultimately matters is does it work.  Click here and here for some material to help answer that question.

Past performance is no guarantee of future returns.  A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value. 

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