Estimation Error: Why Past Returns Aren’t Future Guarantees

Imagine you’re trying to predict the future performance of a baseball player. Let’s say you look at their batting average over the last few seasons. This batting average represents their historical performance, what they’ve done in the past. Now, you might use this historical average to guess how well they’ll do in the next game or the next season. You’re essentially using the past to predict the future.

In the world of finance, we often do something similar with investments. We look at how an investment, like a stock or a group of stocks, has performed in the past. Specifically, we calculate the average return it has generated over a certain period, say the last ten years. This is called the historical average return. It’s like that baseball player’s batting average – a summary of past performance.

Now, when we want to figure out how well an investment might perform in the future, we often use this historical average return as our best guess. We assume that the past is a good indicator of the future. This predicted future return is what we call the expected return. It’s our estimate of what we think the investment will yield going forward, based on what it has done in the past.

However, just like a baseball player’s performance can vary from game to game and season to season, investment returns are also not constant. The stock market is influenced by many factors – economic news, company performance, global events, and even investor sentiment. These factors are constantly changing, and they can cause actual investment returns to fluctuate quite a bit.

This is where estimation error comes in. Estimation error, in this context, is simply the difference between our prediction, which is based on the historical average return, and the actual return that the investment ends up delivering in the future. It’s the gap between what we expected and what actually happened.

Think of it like this: If the historical average return for a particular stock is 10% per year, we might expect it to return 10% next year. But what if next year the stock market has a downturn, and the stock only returns 5%, or even loses 2%? The difference between our predicted 10% and the actual 5% or -2% is the estimation error.

Why does this error occur? Because the historical average return is just that – an average of the past. It’s a snapshot of what happened in a specific period, but it doesn’t guarantee what will happen in the future. The future is inherently uncertain. Market conditions change, companies evolve, and unexpected events occur. All of these can impact investment returns and cause them to deviate from the historical average.

Imagine you’re aiming for a target using historical averages as your guide. Estimation error is like missing the bullseye. You might be close, but you’re not perfectly on target. The further away from the bullseye you are, the larger the estimation error.

Understanding estimation error is crucial when making investment decisions. If we rely too heavily on historical average returns and ignore the possibility of estimation error, we might be setting ourselves up for disappointment. We might overestimate how much an investment is likely to return, leading to poor financial planning or unrealistic expectations.

Therefore, while historical average returns can be a useful starting point for understanding an investment’s potential, it’s essential to remember that they are just estimates. They are not guarantees of future performance. Always consider the possibility of estimation error and the inherent uncertainty of the market when making financial decisions. A healthy dose of skepticism and a recognition that the future is not always a mirror of the past are key to navigating the world of investing wisely.