The importance and limitations of financial market history for investment

In a poll by the CFA institute, 77 percent of investment professionals said a knowledge of financial/economic history is very important to their success, and another 19 percent said it is somewhat important. An interesting follow-up would have been to determine whether those who acknowledge the importance of financial/economic history also recognize its limitations.

This is the tantalizing thing about market history. It can teach you a great deal about investor behavior, but one of the most important lessons is that investors never behave exactly the same way twice. That's why it is vital for investors to know both the benefits and the limitations of financial history.

The benefits of studying financial history

Here are some of the ways that a knowledge of financial history can help you make investment decisions:

  1. Classic market behaviors. There are certain patterns that investors tend to follow time and time again. Perhaps the most classic one is the boom-and-bust cycle, defined by bull markets often starting with a slow and steady build-up, until eventually their success starts to attract more and more investors. The market then crosses over from an financial exchange to a popular craze, and prices accelerate as people no longer need a good reason to buy - people are willing to get into the market at any price at this point. Eventually, though, there is a tipping point and the whole thing comes crashing down. It is amazing that people are able to get sucked into the emotion of these boom-and-bust extremes time and time again, and perhaps a better knowledge of history would help them put those extremes into perspective.
  2. Bounds of possibility. What type of return should you expect on stocks over time? How much could you possibly lose? These are unknowns, of course, but at least history shows both what markets do most often, and also what the best and worst outcomes have been, such as for online trading. This helps investors make decisions about what will probably happen as well as about how to manage risk should the worst happen.
  3. The nature of risk. Seeing how much the stock market is capable of losing in a year or over the course of a bull market is one way that history teaches about risk, but it also shows that there is more to risk than the possibility of losing money. For example, the S&P 500 gained no net ground from the end of 1999 through the end of 2012. And 13 years without progress are more damaging to long-term investors than the year-to-year ups and downs of the market.

The limitations of financial history

For all the benefits of knowing financial history, there are also some limitations of history as a guide to financial decisions:

  1. Changing patterns. Boom-and-bust cycles may occur periodically, but people have trouble recognizing them because there are always some differences. It might be Internet stocks one time, but housing the next. It might be a market as a whole, or just an individual sector, stock or geographic region. The recurrence of market history is a bit like a kaleidoscope: some of the same shapes appear again and again, but they always rearrange themselves in a new way.
  2. The false comfort of back data. Perhaps the most dangerous thing about market history is the way some members of the financial profession rely on historical data to construct models of what will happen in the future. In truth, these data sets are usually not long enough to have any predictive value, but the precision of statistical analysis gives some people a false sense of security.
  3. Infinite interactions. There are just too many economic and financial variables to expect one scenario to precisely resemble a previous one. We are in an era of global trade, an aging population, instant information and shifting oil market dynamics due to both conservation and new drilling methods. How do you compare that set of circumstances with thirty years ago - or thirty years from now?

Think about history the same way human beings process their own experiences. Things that happen to you inform how you act in the future, but you rarely face exactly the same situation twice. Some elements may be similar, but others are clearly different. One of the gifts of the human mind is being able to process how the similarities and differences are likely to shape each new situation relative to how previous ones played out. In short, history is important to decision making, as long as you use your own judgement to make those decisions, rather than purely relying on history to make them for you.

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