The antidote to relying on bad forecasts

Every January Wall Street’s best and brightest release their forecasts for the coming year. And every year, the vast majority are wrong, quite often by a long way. In 2013 the average forecast annual return for the S&P500 among the strategists for the 14 largest stockbroking firms in the US was 17.5% too low. Likewise, at the beginning of 2014 a survey of 92 economists unanimously forecast that US long bond rates would rise, and so far year to date they have fallen by more than 0.5%.

We’re only human

Yet still these forecasts are quoted breathlessly in the media and the forecasters interviewed on radio and television as authorities; and more than 50% of investors with their own self-managed super funds say they rely on the media for guidance with their investment decisions. Psychologists who have sought to explain this phenomenon suggest that humans have a peculiar desire for certainty: we hate not knowing what will happen or why. And we find it hard to remember the lessons when those held up as experts turn out to be consistently wrong.

Nobel laureate Daniel Kahneman, acknowledged as the father of behavioural economics, suggested that we, as investors, have entrenched biases to consistently make decisions that are not in our best interests. Some of those biases include overconfidence (we think we make smarter than average decisions), confirmation bias (we seek facts and opinions that back up our own view and ignore others), hindsight bias (events appear obvious after the fact, therefore the future must be predictable), and extrapolation (we assume that recent facts are indicative of the future).

Relying on the unreliable

One particular psychologist, Philip Tetlock, has done some of the most interesting work on the science of forecasts. He concluded that, statistically, ‘expert’ predictions are the equivalent of random guesses. One of his most striking findings is that analysts that are the most confident in their predictions have some of the worst track records. But the media loves confidence and hates wavering views, so those analysts who are the most adamant or loudest get the spotlight. Not surprisingly then, he found that those analysts with the highest media profiles have some of the worst track records.

Likewise, another study by Isaiah Berlin found that experts who acknowledge that the future is inherently unknowable are perceived as being uncertain – and therefore less trustworthy. William Sherden, author of “The Fortune Sellers: The Big Business of Buying and Selling Predictions”, tested the accuracy of leading forecasters over a multi-decade period and summarized his findings in 11 bullet points:

1. Economists’ forecasts are no better than guesses
2. Government economists’ forecasts are often worse than guesses
3. Long-term accuracy is impossible
4. Turning points cannot be predicted
5. No specific forecasters are better than the rest of pack
6. No forecaster was more expert with specific statistics
7. No one ideological orientation was better
8. Consensus forecasts do not improve accuracy
9. Psychological bias distorts forecasters and their forecasts
10. Increased sophistication does not improve accuracy
11. There has been no discernible improvement over the years

Markets are a random walk

A popular trick question about the table above, which ranks 20 years of returns across eight different asset classes, is can you spot the pattern? It’s a trick because, of course, there isn’t one. In the short-term, like a single year, markets are a random walk. There are so many variables at play that you cannot hope to consistently and accurately forecast where they will be in twelve months’ time.

The antidote to relying on forecasts

Those inbuilt biases make it easy for investors to get caught up in the noise of market commentators who are encouraged to try to make sense of long-term market trends by focusing on day to day events. Instead, there are a few straightforward measures investors can take to avoid the pitfalls that can affect your portfolio when emotion prevails over rationality.

First, remember that investing for most people is a long-term undertaking. It is surprisingly liberating to accept that we can’t predict the future, that it is rare that a single unforeseen event or statistic derails markets for a prolonged period and that at any point of time markets appear to face potentially disastrous issues. That doesn’t mean ignorance is necessarily bliss, but placing your faith in long-term trends and truisms like reversion to mean is likely to be a lot more lucrative and far less stressful than being a slave to short-term gyrations.

Second, make sure your portfolio is appropriately diversified. Retaining exposure across different asset classes provides both protection against a single asset class suffering a downturn and performance from a potential surge.

Third, consulting a financial adviser can bring a professional perspective and an objective view.