Market history can be a lousy teacher

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The philosopher George Santayana taught us that those who do not remember the past are condemned to repeat it. Here's the problem, though: History is a real joker when it comes to delivering investing advice. At any given moment, it's likely to be spewing nonsense.

The past 10 years, for instance, offer eloquent testimony to the virtues of holding long-dated bonds and Canadian real estate. Both have had nice run-ups, so recent history would appear to vote strongly in favour of loading up on 30-year bonds and suburban bungalows.

But if you look back over the past half-century, you'll see erratic bond returns, including long periods during which bonds were losers. Canadian home prices climbed—and since 2000 they've enjoyed extraordinary gains, out of all proportion to earlier decades.

What, pray tell, is history's message in these cases? I think it's that the market can remain irrational for far longer than most investors realize. Or, to put it another way, investing is logical—but it requires a long, long time for the logic to make itself clear.

Cliff Asness, the deep thinker behind the investment firm AQR Capital Management, recently demonstrated this by chopping the past 45 years of U.S. market history into five-year slices. For each slice, he calculated the returns an investor would have received from government bonds, stocks and commodities.

In theory, the outcome is simple to predict. Stocks should be volatile but highly profitable. Commodities should also provide a decent return, but with even more ups-and-downs. Bonds should offer the lowest return, but with the smallest wobbles.

Yet if you look at each five-year slice, they rarely resemble what theory would forecast.

In the 1970s, commodities generated lavish profits while stocks stunk and bonds disappointed. In the 1990s, commodities languished while stocks produced absurdly high returns. Yet from 2000 to 2004, stocks lost money, while bonds produced high returns and commodities shot skyward.

But wait a minute. Peer back over the entire 45 years, from 1970 to now, and the total returns line up just the way theory predicts. Stocks are on top, with commodities a notch below, and bonds on the bottom, but with far less volatility than the other two assets. Darn it, the academics do know what they're talking about!

An investor can take a few lessons from this demonstration.

The first is that you're likely to spend much of your investing career in markets that don't seem rational at all. Most of us don't start investing seriously until we're in our mid-40s, so your returns during many of your prime investing years may bear no relationship to what theory would suggest.

The second is that patience pays—and by patience, I mean regarding your investing as a 30- to 40-year journey, not a one-year sprint.

The final—and perhaps most important—point is that it's dangerous to extrapolate the results of recent years. Returns have a nasty way of snapping back to type. Canadianswho are heavily invested in long-term bonds and real estate right now should study Asness's history lesson.