Can past performance predict future performance?

Most investors are well aware of the SEC's warning that past performance isn't an indicator of future performance. That warning often leads to questions like: "If past performance isn't predictive, why do you believe that the past outperformance of value stocks over growth stocks and small stocks over large stocks is predictive?" The answer lies in understanding two key points.

First, the SEC's warning relates directly to the performance of actively managed mutual funds. The warning is required because an overwhelming body of evidence demonstrates that for these funds even long periods of outperformance aren't predictive -- while some funds do outperform, it's no more than is randomly expected.

Second, the SEC's warning doesn't apply to asset classes, a group of assets with similar risk and reward characteristics. To address the question of whether the past performance of asset classes is predictive of future performance, we'll begin by thinking about stocks and their performance relative to riskless one-month Treasury bills.

It's safe to say that most investors not only know that stocks have provided higher returns than Treasury bills but that they also expect stocks will continue to provide higher returns. That's because stocks are riskier than Treasury bills, and investors demand a risk premium in return for accepting the increased risk.

They also know there's no guarantee that stocks will outperform. It's an expectation, not a guarantee. And they know that the longer the time horizon, the more likely it is that stocks will outperform.

Why can they have that expectation and be confident about it? Because not only is there a logical risk explanation, but the evidence of an equity premium is both persistent (over long periods and covering many economic cycles) and pervasive (all around the globe). It's that persistence and pervasiveness (with sample tests to reduce the risks of what's called data mining) that gives us confidence.

The risk explanation also means it cannot be arbitraged away. And statistical analysis can be helpful by demonstrating that the outcomes are statistically significant -- reducing the odds that the results are nothing more than a random outcome.

The same persistence, pervasiveness and statistical significance apply to the value premium and the size premium. They also apply to the momentum premium and the profitability premium (highly profitable firms outperform). An earlier post offers a detailed look at the different premium types.

While there's little debate that risk explains the size premium, there are disagreements about the other three premiums. The greatest concerns the source of the value premium. For example, economists have found that value stocks have characteristics that are intuitively risky.

• Higher volatility of both earnings and dividends.
• Higher leverage.
• Higher standard deviation.
• They are more risky in bad times (and less risky in good times, though to a lesser extent). Because investors are risk averse they require a large premium to accept that risk.

On the other hand, many studies find that the source of the value premium is at least to some degree a behavioral error, an anomaly. These studies find that investors persistently overprice growth stocks and underprice value stocks. The source of the mispricing is that investors persistently underestimate the power of the reversion to the mean of abnormal earnings growth, be it abnormally high or abnormally low. They may also confuse the familiar (growth stocks) with the safe, and thus overpay for growth stocks.

Given that both sides have good arguments, a third explanation seems likely -- there should be a value premium because of the incremental risks, but the premium has been too large for the risks to fully explain. In other words, it may not be a free lunch, but it might at least be a free stop at the dessert tray.

While both the momentum and profitability premiums also have explanations on both sides, the weight of the evidence favors a behavioral story. And if it's behavioral, it runs the risk that once it's discovered the very act of exploiting it will cause it to disappear. Is that likely in these cases?

While that's certainly a possibility, the existence of the momentum premium has been well known for decades. Yet, the momentum premium persists not only in the U.S., but is pervasive both around the globe and across asset classes (including currencies, commodities and interest rates). The same is true of the value premium. It's pervasive globally as well as across asset classes. While a risk explanation provides more confidence that a premium will continue, persistence over time and pervasiveness across markets does provide some level of confidence.

The evidence for the profitability premium is relatively more recent, giving perhaps less confidence that it will continue (because the weight of the evidence seems to be on the behavioral explanation). However, the evidence is persistent across cycles and pervasive across the globe.

Summarizing, the longer the premium's persistence and pervasiveness, the more we can have confidence that we should expect it to continue. And the weight of the evidence suggests that just as we should expect that the equity premium over Treasury bills will continue, we should also expect value stocks, small stocks, high-momentum stocks and highly profitable stocks to provide premiums as well.

Still, the expectation should come with a warning that there's no guarantee this will happen.

The bottom line is that because risk explanations provide more confidence than behavioral ones, you might consider allocating more of your portfolio to the factors that rely more heavily on a risk story. However, it doesn't mean you should ignore the other factors.