Improving Your Investing Outlook
Most investors have seen a note on their documents saying something like: "Past performance is not necessarily indicative of future results." This is directly followed by a chart of past prices and how different investments have done historically, which then becomes the foundation for the investment decision. So, the question is, if the past isn't indicative, why is it so prevalent as the basis for decision making? And if it is indicative, why all the disclaimers?
Predicting the Future
During the two major bubbles of the recent decade (dotcom and real estate), many investors didn't get into the market until they saw prices moving upward. Then, in hopes of prices continuing to skyrocket, they took a leap of faith, often putting money at risk that they couldn't afford to lose. This became self-fulfilling, as prices then shot up ever higher as more buyers jumped in. When there were no more buyers coming into the market, it collapsed. The past was no longer an indication of the future. (Enron is a classic example of greed gone wrong - and how investors were led astray. Find out more in Enron's Collapse: The Fall Of A Wall Street Darling.)
The Buffet Example
However, let's not give up on the past just yet. Successful investors, such as Warren Buffet, have a history that is hard to deny. Buffet's Berkshire Hathaway has a compounded annual gain from 1965-2008 of 20.3%. This compares to the S&P 500 of 8.9% over the same period. It's hard not to conclude, given decades of stellar performance, that he will do well again next year.
Also, there are a considerable amount of professionals working in the financial markets that use technical analysis to decide how to buy and sell securities. Technical analysts use charts of historical data, like price and volume, to determine future moves. This is clearly using the past to predict the future, and, as is used in virtually every trading firm, it's hard to conclude there isn't anything to it.
Creating the Future
If enough traders all see the same historical data and act on it together, they are creating the future based on the past, not predicting it. For example, if a stock breaks out to the upside, some technical analysts will believe that the pattern will continue and buy the stock. This will push the stock higher. Other traders will also buy the stock, thinking that other technical analysis traders will see the pattern and jump in. Beyond technical analysis is fundamental analysis. In this method, data from companies is analyzed using financial models to determine value and make a buy or sell decision based on current price. Buffet's success is largely attributed to valuating companies properly and only buying the ones that he feels have great future potential. This is another example of the using the past to predict the future. However, Buffet has been wrong in either picking a company that didn't perform well or missing out on one that did, on occasion. (Find out how fundamental analysis can be applied strategically to increase profit, in Fundamental Analysis For Traders.)
Obviously, the past can sometimes predict the future. As muddy as that answer seems to be, it should be crystal clear that there is no way to predict the future with certainty. For example, Buffet may be highly predictable, but at one point, many people thought that Enron, WorldCom, and others were also rock solid. If the buy or sell decision is solely based on past data, the difference between Berkshire and those other firms is ignored. While some people may find comfort in the certainty provided by that hindsight, it's still the future that matters.
The Bottom Line
Think of it this way: If you were driving down the road and only looking in the rear view mirror, it's likely that you would eventually drive off a cliff. Instead of focusing on what matters and the foggy road ahead, many people use the clear view in the rear view mirror and let past events guide their decisions. If predicting the future based on past data isn't possible, ignoring the foggy future and focusing on the clear rear view provides overconfidence, not better decision making. Focus in investing as you do when driving: mostly on the windshield, only glancing in the mirror on occasion, and the probability of driving off a cliff will be far less.