Base Effects Don’t Just Come From Your Speakers
You may have started hearing about “base effects” in the business news media, when analysts are talking about inflation or other financial topics. Thankfully, they are not talking about a new sound system you need to learn, but an important aspect of comparing financial data points. The term refers to the change in results that are seen simply by using different starting dates and what was happening in the economy at that time.
Financial analysts like to compare data over set time periods as a means of estimating if values are too high or too low, and as a source for predicting future trends. Under more stable circumstances, that can be instructive. But it is important to remember if there were any significant outlier events (i.e., a global pandemic that caused a massive economic shutdown) that may cause the “base” year data you are using to be less statistically relevant. For example, in terms of inflation, while the level may be rising currently, inflation can be exaggerated in the short term if you are comparing it to a time period that saw a significant downward shock. An investor must account for those exogenous shocks before making any future assumptions, because they can quickly reverse themselves with just the passage of time. Another example can be found looking at stock market returns over a rolling 12-month time period. This past year, the one-year return for an all equity portfolio looks quite different if you pick January 2020 as the starting point for comparison, as opposed to April 2020.1 The April annualized return will most likely outperform in large part due to the large drop in the stock market in March of 2020 as opposed to anything done in the first three months of 2020.1
Context is everything, and numbers can be “massaged” to tell any story. Be inquisitive and aware of the timing, use of percentages and any outliers that might be impacting the story and/or the results. Paying attention to the inputs to any financial data is necessary to make sure the results don’t have too much “base.”
1Bloomberg/Time Return Analysis. S&P 500 Index return Jan 2020 to Jan 2021 = 15.727%. S&P 500 Index return March 2020 to March 2021 = 47.433%
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