Follies of forecasting
An edited version of this article was published in the 17 Apr 2017 print issue of TODAY. (Online version released 15 April.)
Below is our original article in full.
At the start of every day, week, month and year, investors often seek direction from financial experts on where they should be invested. It thus gives the financial industry a golden chance to carpet-bomb investors with predictions of what the current year holds, and why they should be invested in their products or in accordance with their advice.
Typically, these forecasts are centred on either avoiding the next great financial crisis (fear), or taking advantage of the next great money-making opportunity (greed). When faced with a multitude of seemingly diverse (and often conflicting) conjectures about the future, investors often have a hard time deciding between either sticking with their long-term plans or reacting to these short-term (and often erroneous) calls.
Do you realise that you have never seen a newscaster saying, “The stock market is functioning normally, like it has for the past 90 years” or, “Nobody knows what the STI Index will look like next Monday”? Instead, you commonly find forecasts pronouncing: “We like the three local banks as the rise in interest rates will likely increase their profits this coming year”, or, “The Oil and Gas sector continues to come under pressure, so we are underweight on most commodity plays”. Predictions are almost always headline-grabbing, emotion-inducing and, quite often, stomach-churning. Such audacious forecasts are attention-seeking, and catch the eye, but their application to one’s overall investment plan is often hazy and suspect.
Take, for example: in early 2016, when the turmoil in Chinese stocks and the collapse of oil prices were spreading around the world, the news was abuzz with warnings of an upcoming bear market. Well-known billionaire investor George Soros lamented that it looked like "the 2008 crisis all over again", BlackRock CEO Larry Fink warned that stocks may fall another 10%, and even respected hedge fund managers Stanley Druckenmiller and Carl Icahn were sounding death knells for the stock market. Citi described the global economy as trapped in a "death spiral". The Royal Bank of Scotland even went as far as concluding that the market was in for "a cataclysmic year" ahead and told all investors to “sell everything”. Investors who heeded all this expert advice would have been left kicking themselves as the year actually turned out to be a positive one for global equities and US stocks.
In the middle of the year, the consensus was that BREXIT would be very bad for markets. That sparked a flight to safe assets and much turbulence in risky assets. Well, the market did initially react according to the gloomy forecasts, but for only two days after BREXIT, after which it promptly made back any losses!
The final batch of predictions intensified as the US headed towards the Presidential Elections in November, with an overwhelming number of investment institutions and banks predicting a positive scenario for a Clinton victory and a horrible one under Trump. Large financial institutions like JPMorgan speculated that markets were likely to tumble further in the event of a Trump win; Citi forecast a market correction in the 5 percent range, whilst Barclays put the potential fall at 11-13 percent. The market eventually did the exact opposite of these forecasts, ending the day positive and sparking a “reflation” rally.
So, what happened? How could all these experts, with their armies of analysts, years of investing experience, market smarts and access to a massive array of data get it so wrong, and three times in a year? If investors knew the actual success hit rate of the financial industry, they would be alarmed. The Philadelphia Federal Reserve, together with the US Department of Commerce, have a dataset running from 1970s on the Real GDP Growth of the US compared against a survey of professional forecasters and economists. It is shocking to note that not one person has accurately predicted an economic recession for the past 40-odd years.
Why is this significant, you may ask? Investment managers typically link equity returns to the economy – a positive economy means positive equity markets. Observant readers would have noticed that the world had gone through at least six major bear markets during this period.
An independent statistician, Mr Salil Mehta (formerly the director of research and analytics for the United States Treasury’s Troubled Asset Relief Program), has blogged about this topic. He notes that the forecasts which the major investment houses provide do far worse than random chance. Studying forecasts issued since 1998, he notes that analysts almost never like to call for a market decline – they predominantly issue bullish forecasts year after year, with only 9 percent forecasting a market decline. The spread on the forecast errors was also huge, larger than can be expected from mere chance. Statistically speaking, these forecasters were “actively adding negative value” – essentially destroying value by issuing spurious numbers.
But why do investors continue to follow forecasts? Imagine hearing from experts that equities are currently “overpriced” and that one should hold cash. The allure of being able to outperform the ‘dumb investors’ is what drives behaviour. So, how accurate must these predictions be for them to be useful to investors? In a 1975 study titled “Likely Gains from Market Timing”, Nobel Laureate William Sharpe concluded that a forecaster needed at least a 74% accuracy rate in order to outperform a passive-indexed portfolio at a comparable level of risk. Incorporating Sharpe’s research, the CXO Advisory Group created a table comparing the accuracy of well-known market-timing gurus. Even the most accurate of the lot, Ken Fisher, registered a 66% accuracy – which means that even the best guru failed to beat the benchmarked portfolio.
The track record of professional money managers trying to profit from supposed market mispricing and following market themes shows that making frequent changes to one’s portfolio creates underperformance. Evidence of these shortcomings can be found in data from S&P Dow Jones SPIVA scorecards, where they measure the returns of active money managers versus passive indices. It is thus not surprising that for Developed markets like the US, a stunning 91% of active funds underperformed the index over a five-year period. Even for Emerging markets like Brazil, where the assumption is that active managers would be able to do better, only 28% of active managers were able to beat the index over the same period.
Steve Forbes, the publisher of Forbes Magazine, once tellingly remarked, “You make more money selling advice than following it. It’s one of the things we count on in the magazine business—along with the short memory of our readers.”
So, if the game is rigged against the average investor, what should one do? Instead of paying high fees, churning your portfolio and following forecasts for likely negative benefit, the evidence points to simply trusting the capital markets and staying invested in a risk-appropriate portfolio, despite the outpouring of negative news.
You need to stick with your original investment plan – be it for retirement, education funding for your child or just simply trying to make your money work harder. It is prudent for investors to stay away from exciting, flavour-of-the-month type investments, especially by not investing according to the latest exciting or scary forecast.
By just putting your money in broadly-diversified holdings, like boring index funds, and holding for the long term, the evidence says that you have a much higher probability of making money in the long run. It is folly to do otherwise.
So, what should investors buy now, and what's our forecast for the stock market this year? We say it would be better to flip a coin!