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The Danger of Extrapolation:
Don’t Let “Silly” Torpedo Your Portfolio
By: Bob DiMeo, Managing Director
As humans we often disproportionately rely on recent occurrences to shape our thoughts regarding future events. But when we as investors use short-term results to forecast, we do so at our own peril. 

As a reader of this column or an attendee at our conferences, you’ve likely seen me address the dangers of extrapolation in investing. I’ve talked about the growth trajectory of Elvis Presley impersonators (from the late ‘60s to the early ‘90s) and how if that rate persisted, then by 2020 one of every three Americans would be an Elvis impersonator. I like the Elvis example because it helps us appreciate how silly it can be to extrapolate recent trends. 

Similarly, here are some recent trends in investing that may seem just as silly when we look back at them 3-5 years from now:
  1. Why would I own anything other than large U.S. equities in my stock allocation? It’s true that large cap domestic stocks have shined (the S&P 500 has annualized nearly 12% over the past 5 years through March 31). Yet if you looked at returns in mid-2009, the S&P 500 averaged a loss of 2.2% over the preceding 5 years. People were questioning why they’d ever want to own large cap stocks.

  2. Shouldn’t I dump all my bonds if rates are going to rise? Investors are understandably concerned about rates eventually rising; however, history shows that bonds, as represented by the Barclays Agg., have generated positive total returns in each of the last six rate hike cycles. We continue to believe a broadly diversified fixed income allocation (core, TIPS, high yield, foreign, etc.) can play a meaningful role in certain portfolios by reducing risk and volatility. 

  3. Some big institutions are dumping hedge funds…shouldn’t I? It’s true that since the financial crisis the S&P 500 has handsomely outperformed hedge funds though it’s important to appreciate we’ve perhaps never seen a stock rally more driven by central bank intervention in all of history. It’s been a challenging environment for hedge funds that attempt to mitigate risk and exploit subtle opportunities. There’s also a lot made of some investors, like the states of Illinois and California, reducing hedge fund exposure. Still, successful endowments like Northwestern and Yale have reportedly increased their allocation to hedge funds. When we look back in 5 years, it’s a good bet that the schools had it right.
In closing, allow me to share this spot-on cartoon which, like the Elvis impersonators, superbly illustrates just how silly extrapolation can be.
As always, please contact any of the professionals at DiMeo Schneider & Associates, L.L.C. for more information on this and related topics.
This report is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any dissemination or distribution is strictly prohibited. Information has been obtained from a variety of sources believed to be reliable though not independently verified. Any forecasts represent median expectations and actual returns, volatilities and correlations will differ from forecasts. Past performance does not indicate future performance.  
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