Ariel Investments’ monthly commentary for the month ended August 31, 2014 H/T Dataroma 

Ariel Investments has noted before that standardized return periods, especially shorter-term ones, can unfortunately drive investors to make poor decisions. To illustrate the point, below we discuss the trailing three-year returns of the equity markets. These three-year numbers have been rising for several months, and we think they are likely to rise next month—fairly substantially, in fact. This observation is not in any way a prediction; it is based on the known past rather than on the unknowable future.

Ariel Investments: Market Outlook

Nobody knows what will happen in September 2014, but we do know what happened in September 2011. That is, a short bear market that many seem to have forgotten came to a close. Specifically, from May 1, 2011, through September 30, 2011, the S&P 500 Index fell –16.26%, the MSCI EAFE Index dropped –22.19%, and the Russell 2000 Index lost –25.10%. Many use a drop of –20% as the measurement of a bear market and largely pay attention to the large-cap market, so some view the event as a simple correction. On the other hand, Russell and other experts use a –15% drop to define bear markets; that is our standard at Ariel. Given small caps’ –25% decline alongside sharp drops globally, from our perspective it clearly merits the label of bear market.

Whether or not you call the five-month drop in 2011 a bear market, it certainly greatly affects the current three-year return numbers. Obviously, as new monthly returns become a part of the three-year record, older months “roll off.” For this reason, standardized period returns can jump or plummet around inflection points that happened years ago. Below we show the last three-year returns from the past five months to illustrate the point.

Ariel investments

Because we know returns in September 2011 were poor, ranging from –7% for the S&P 500 to –11% for the Russell 2000 Index, we can expect the three-year returns to rise this September (unless it happens to be a very bad month). The problem with this phenomenon is: when an investor takes the above information at face value, he might get the impression that, given the rise in trailing three-year returns from April 2014 to August 2014, the EAFE Index is roughly twice as “good” as it was a few months ago, while the S&P 500 Index is about 50% better. Note that this change occurs not so much because new information arrives, but rather because old information becomes excluded. This is one key reason Ariel maintains a strong preference for using two different return period standards: market cycles, which span the various bull and bear markets, and each portfolio’s since-inception period. Because their starting points do not shift when new returns join the dataset, they do not ignore relevant data.

Ariel Investments: Fund Performance

The moving windows that trailing returns provide would have a fairly limited impact if investors used them well; unfortunately, we know many investors often do not do so. Regulators mandate that asset managers note that past performance is no guarantee of future results. This wise but often unheeded recommendation may even understate the issue. Indeed, to the extent that historical returns are predictive, they tend to be contra-indicators. Since 1926, according to Morningstar, large-cap stocks have returned an annualized +10% and small caps have gained an annualized +12%. Investment returns tend to revert toward the mean; that is, relatively high past returns often foretell lower future returns, while below-average returns can suggest potential outperformance going forward. Yet, as you know, most investors become more optimistic when recent gains are unusually high and more pessimistic when the latest returns are subpar, driving a buy-high and sell-low pattern.

What then, is an investor to do? In this case, there is one specific thing: recognize that returns are not suddenly improving for equities here and abroad—a bear market is simply receding a bit further into the past. More generally, avoid using short-term returns to drive your investing activity, especially rolling periods that may ignore inflection points. Indeed, avoid market timing as much as you can. Develop a game plan and stick to it, and if you decide to make opportunistic, tactical investments, rely on valuations rather than on returns.

See full Ariel Investments Monthly Commentary in PDF format here.