“Prediction is very difficult, especially about the future” – Unknown
Every time the calendar year rolls over, investment pundits scramble to explain last year and predict the next. I spend the first couple weeks of each new year looking over these explanations and predictions as they come in, curious if any of them offer even a hint of usefulness to their audiences. Some get a lot of attention from the media and the investing public, driving conversation and even investment action, for better or worse. The truth is, it’s mostly for the worse.
Jason Zweig, the thoughtful author of “The Intelligent Investor” column for The Wall Street Journal (his column is always worth a read) had a good article on the subject on the last day of 2014. It’s titled “Lessons From Year of Market Surprises,” and in it he recounts how poorly recent predictions have turned out. He reminds us that interest rates were supposed to rise sharply in 2014 (they fell), oil prices were supposed to increase (they’ve been cut in half), and the stock market sell-off in October was supposed to be the beginning of a major correction (we’ve seen new highs since then, and the S&P 500 finished 2014 up over 13% including dividends). Practically all the industry strategists predicted similar things, and they all got it wrong last year.
What about those portfolio managers who make a living off “forecasting” markets as part of their investment process? They got pummeled last year by the very indices they were supposed to beat. A lot of that is simply bad stock picking, but a good portion of it is also the result of forecasts that didn’t come true. And 2014 wasn’t a fluke…actively managed strategies regularly fail to beat their appropriate indices.
Academics know how bad forecasters are. Brad Barber of the University of California at Davis has thoroughly studied the subject and maintains that there is no evidence that analyst estimates or forecasts add any value. Even folks whose job it is to issue forecasts don’t believe they are accurate. Ed Lazear, a professor at Stanford’s business school and former chair of the Council of Economic advisors, has commented on how unreliable forecasts from the Office of Management and Budget, the Council of Economic Advisors, the Congressional Budget Office, and the Department of the Treasury are and that “government forecasters might as well use a Ouija board.” Data reveals that the investment industry is no better at it.
My own personal experience with forecasting supports the research. At every previous firm for which I’ve worked, we always had our own forecasts. It’s a core part of what any typical investment firm does, and it tends to drive portfolio strategy at firms with centralized money management. What’s more, if done rigorously, it drives analyst research on individual securities when the firm’s forecasts are used as inputs for each analyst’s modeling efforts. Predictions over the short and medium term have a considerable impact on asset allocation decisions and security selection. The dirty secret, though, is that the forecasts driving our models and portfolios were often incorrect. There was always some curve ball thrown at us during the year for which we had not accounted, significantly impacting returns.
Those return effects were sometimes positive and sometimes negative. But it didn’t matter because our marketing group always figured out a way to explain our missed forecasts so we didn’t look as clueless as we actually had been in the case of negative impacts, or we looked smarter than we actually were when events helped out our portfolios. Clients were never the wiser…while the industry is lousy at forecasting the future, it’s very good at making folks believe it can.
As you can probably tell by now, the title of this piece is somewhat misleading…I’m not about to make any projections for 2015. Knowing the impossibility of doing it accurately, it seems a foolish exercise and a general waste of time, yours and mine. Unfortunately, the rest of the industry doesn’t feel the same way. Pundits are all cranking out their predictions as if they know something everyone else doesn’t, and they are juggling their portfolios based upon their crystal ball. Rather than investment portfolios, most investment managers create speculation portfolios, and that is immensely troublesome.
The reality, however, is that responsible portfolio managers do need to look out into the future and consider how the world might evolve. But that means well into the future…5/10/15 years out, and think about the really big things that change glacially, not what might happen over the next 6-18 months. It’s those longer term issues that we can have a better idea about since they change slowly and require an incredible amount of variables factoring into their development. Over time we can watch things evolve and gain a level of confidence that our strategy is positioned to benefit from those developments. And if things begin to go in a different direction, because of the sheer number of variables involved we can have a certain amount of confidence that the game has changed and we need to change with it.
Realize, too, that it’s unlikely that we’ll be ahead of it all (unless we get lucky, which does happen from time to time), but I don’t think that’s the job of a responsible portfolio manager. Portfolio managers should be making every effort to get his/her clients their fair share of global growth, not gambling with their clients’ assets by trying to predict the unpredictable. And besides, the data is clear that those who try the latter always lose over the long run. And so do their clients.