“I don't read economic forecasts. I don't read the funny papers.” — Warren Buffett
“One day, the world will indeed end. The sun will run out of hydrogen fuel, turn into a red giant star, and expand until it engulfs the earth. That is about 5 billion years in the future. In the meantime, you can safely ignore all other forecasts.” — Barry Ritholtz
It's just amazing how long this country has been going to hell without ever having got there. — Andy Rooney
It is very hard to ignore predictions about the stock market, especially when the forecast calls for rain. To make matters worse, the financial press often preys on our “fight or flight” instincts by featuring the forecasters’ doom-and-gloom predictions. After all, it’s what sells their stream of stuff.
As we’ll describe today, the more urgently a financial pundit is pressing you to buy this or sell that based on imminent past or future events, the more reasons you’ve got to fight your impulse to react. As Dimensional Fund Advisors’ Jim Parker wrote about here, confusing fleeting trends with permanent conditions is like mixing up the difference between the weather and the climate.
What the Talking Heads Aren’t Telling You
If you think about hot financial predictions in a logical fashion, why would these prognosticators have to work at all if they could accurately predict the future? Why wouldn’t they use their insights to enrich themselves rather than tipping their cards to us?
Someone with forecasting talent could implement financial instruments to leverage their assets for something like a 20:1 payoff. If they really did see a 20% correction coming, they could easily use leveraging to earn a 400% return, just as a few lucky souls did in the movie, “The Big Short.” They would only have to do this a few times before they could get rich quick and call it a day. (Of course, as we saw in “The Big Short,” you only have to be wrong once – or even not right soon enough – to be wiped out by leveraging!)
Chicken Little Forecasting
Think of it this way: I could predict every blizzard in Boulder by forecasting that a blizzard is about to fall every time I saw a cloud in the sky. Similarly, a plucky prognosticator could predict an impending 10% market decline whenever there’s a hint of bad news on the horizon. Mind you, there’s no substantial evidence that every appearance of bad news causes a market decline, but because the markets tend to drop at least 10% about every 7 months for all sorts of reasons, our “sky is falling” Chicken Little faces not-bad odds of being correct now and then through random chance.
The Track Records of an “Etch A Sketch”
By now you might be thinking: “But won’t a false prophet eventually be found out?” Unfortunately, the answer is, probably not. Are you familiar with the classic Etch A Sketch? No matter how big a mess you make, you can wipe your slate clean in seconds.
Financial forecasters seem to enjoy similar treatment. It seems as if there is little to no penalty when they’re wrong, because no one monitors their predictions or seriously calls them to task when they lead their followers astray.
Instead, whenever someone does get lucky and makes an important prediction or two that happens to come true, they are heralded as a guru and people flock to hear what they have to say next … at least until the next guru comes along and the last one is forgotten.
Luck or Skill?
If you’re up on your financial forecaster lore, you may remember Elaine Garzarelli, who predicted the 1987 stock market crash. Her seemingly prescient prediction allowed her to start her own mutual funds, which were eventually folded into other mutual funds or liquidated due to poor performance.
We could cite countless other illustrations of yesterday’s financial superstars fading fast. Bottom line, when the talking heads on TV get a prediction right, we can’t know at the time whether it was due to luck or skill. What we do know is that, in markets that are highly efficient, it’s far more likely to be luck, as appears to be the case for Garzarelli.
Our “What Have You Done for Me Lately?” Bias
We also need to consider your own biases, especially recency bias. Behavioral finance informs us that investors tend to assume that recent market trends are more likely to happen again or to keep happening. This too can aggravate your tendency to give a financial forecast greater weight than it deserves.
For example, whenever one corner of the market has underperformed for a while, we see forecasters predicting continued pain. “It’s the new normal,” they proclaim, wherever a downturn has lingered. We also see investors fleeing that holding and piling up on whatever has recently been doing well.
Then the forecasts and the fund flows reverse when the tables turn.
This is recency bias in action. For example, as “Advisor Insights” blogger Matthew Carvalho described in April 2016, there were a host of dire market predictions in the beginning of the year. Some investors likely exited or remained out of the market as a result. Carvalho observed: “One prediction that was spot on came on January 1 from the Associated Press: Expect less and buy antacid. Looking backward, that was apt advice for daily market spectators; however, if you took a 3-month vacation and didn’t check your balance, you’d return thinking the first quarter was normal — no antacid needed.”
Perfect Timing … or Else
Another problem with fleeing the market in response to gloomy forecasts is that you must correctly time both your exit and reentry points. It may be tempting to sell when the market is down, but you’re selling low, incurring trading costs and potentially facing taxable gains. Then you have to determine when it’s time to jump back in. Most investors end up buying back in when prices are high, incurring another round of trading costs.
Trying to successfully repeat this process over and over is expensive, frustrating and likely fruitless. According to this DALBAR study of investor behavior, market timing caused average investors to realize only a fraction of the stock market gain that would have been available to them. For the 20-year period ending December 2014, the average equity fund investor earned 5.19% annually while the S&P 500 Index returned 9.85% annually. It was even worse for the 30-year period with the average equity fund investor earning 3.79% annually and the S&P 500 returning 11.06% annually.
What’s an Investor To Do?
We believe in the Efficient Market Hypothesis, which says that all available information is incorporated into the market very quickly. The markets aren’t perfectly efficient, but they’re efficient enough that your best chance to enjoy a successful investment experience is to forget the forecasts and focus on far more timeless advice:
Invest for the long-term. Capture available market returns within your risk tolerances and according to the best available evidence. Aggressively manage the factors you can expect to control and disregard the ones that you cannot.
These principles guide the actions we’ve advised all along. We will continue to embrace them unless compelling evidence were ever to inform us otherwise. They are the ones that serve your highest financial interests, which is our highest priority as your advisor.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail email@example.com.
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