Skip to main content

Advertisement

Advertisement

Follies of forecasting

SINGAPORE — Investors often seek direction from financial experts on where they should be invested, which gives the financial industry a golden chance to carpet-bomb investors with predictions of what the current year holds. 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 sticking with their long-term plans or reacting to these short-term calls.

SINGAPORE — Investors often seek direction from financial experts on where they should be invested, which gives the financial industry a golden chance to carpet-bomb investors with predictions of what the current year holds. 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 sticking with their long-term plans or reacting to these short-term calls.

When was the last time you heard a newscaster say, “The stock market is functioning normally, like it has for the past 90 years”? Instead, you commonly find forecasts making stock picks or recommendations on sector portfolios. 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.

In early 2016, when the turmoil in Chinese stocks and the collapse of oil prices were spreading around the world, the warnings of an upcoming bear market were rife. Billionaire investor George Soros lamented that it looked like “the 2008 crisis all over again”. Citi described the global economy as trapped in a “death spiral” and The Royal Bank of Scotland even went as far as to conclude that the market was in for “a cataclysmic year” ahead and told investors to “sell everything”. Investors who heeded 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 the United Kingdom’s exit from the European Union, Brexit, would be very bad for markets. That sparked a flight to safe assets and much turbulence in risky assets. While the market did initially react adversely to the gloomy forecasts, losses were corrected within days after the news was absorbed.

The United States Presidential elections last November saw an overwhelming number of investment institutions and banks predicting a positive market scenario for a Clinton victory and a horrible one under Trump. JPMorgan speculated that markets were likely to tumble further in the event of a Trump win, and Citi forecast a market correction in the 5 per cent range, while Barclays put the potential fall at 11 to 13 per cent. The market eventually did the exact opposite of these forecasts, 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? The Philadelphia Federal Reserve, together with the US Department of Commerce, have a dataset running from the 1970s on real GDP growth of the US compared against a survey of professional forecasters and economists. It is shocking to note that not a single person from this group of Wall Street professional forecasters and economists has accurately predicted an economic recession for the past 40-odd years.

Why is this significant? Investment managers typically link equity returns to the economy — a positive economy means positive equity markets. Observant readers would have noticed that the world went through at least six major bear markets during this same period.

Former director of research and analytics for the US Treasury’s Troubled Asset Relief Programme Mr Salil Mehta says 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, and predominantly issue bullish forecasts year after year, with only 9 per cent 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 per cent 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 per cent 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 Indices Versus Active (SPIVA) scorecards, where they measure the returns of active money managers versus passive indices. It is not surprising that for developed markets like the US, a stunning 91 per cent 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 per cent of active managers were able to beat the index over the same period.

Steve Forbes, the publisher of Forbes Magazine, once 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 children or just 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 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.

 

ABOUT THE AUTHOR: Aw Choon Hui is the deputy CEO of GYC Financial Advisory, a licensed financial adviser and registered fund management company.

Read more of the latest in

Advertisement

Popular

Advertisement

Stay in the know. Anytime. Anywhere.

Subscribe to get daily news updates, insights and must reads delivered straight to your inbox.

By clicking subscribe, I agree for my personal data to be used to send me TODAY newsletters, promotional offers and for research and analysis.