Following forecasts? Prepare to be wrong

Written by multiforte on . Posted in News

The investment commentator in a well-respected financial report recently proclaimed, “We’re going to see a gradual pick up in the US economy with a rate of growth of 2.8% this year and 2.9% in 2015”.

Experimental monetary policy (quantitative easing), 300 million-plus people with unequal wealth, sluggish employment growth, shifting interest rates and weather – and they’ve figured it out to a tenth of a per cent?

It’s no wonder that Harvard academic and author of the just-released Fortune Tellers: The Story of America’s First Economic Forecasters, Walter Friedman finds that we simply can’t trust economic forecasters.

“No one has been ever been able to produce a reliable method of forecasting and making predictions of where the economy is going to – and they won’t be able to”.

Friedman argues that there is a danger in following forecasters, and any evidence of past accuracy is based purely on luck.

“I think you need to think like forecasts a bit like treasure maps, in that you always have to skeptical of the person who would want to print and sell treasure maps en masse”. If you were in their shoes, he argues, it would be much better for you to keep a treasure map if you have a valid one and get the treasure yourself.

“You have to keep in mind that these people are trying to sell their predictions and that persuasion is as big a part of this industry as prediction is.”

In investment management, we see persistent evidence of the inability of prediction-based approaches to consistently outperform the market. Survey after survey shows most fund managers underperform the market by the margin of their fees and the ones that do outperform don’t tend to repeat this feat.

Instead, we work on the view that prices are a fair reflection of the information that’s out there at any point in time.

This view is grounded in empirical evidence – in particular the work of Nobel prize winner Professor Eugene Fama.

Fama argues that most markets are efficient – meaning that prices change constantly to reflect all publicly available information coming into the market. When news happens, prices quickly adjust to reflect that news. So, for example, if there’s bad news on the economy, share prices tend to take a hit as investors collectively downgrade their expectations for future profits.

Importantly, this doesn’t mean that there are no anomalies in security prices. The price of a security represents the combined wisdom of thousands, if not millions of buyers and sellers, all working off the same information. What it does mean is that unless you have inside information, you will find it pretty tough to find those anomalies and pick stocks in order to beat the market.

So if you can’t do better than the market what can you do? We believe your starting point is to clarify what you wish to accomplish – and the financial resources you will need to achieve that. Then, work out how much risk you are willing to take. Third, invest in a way that ensures you diversify away avoidable risks – like holding too few securities, or betting on countries or industries. Finally, once you set up your portfolio with sound investment principles you should review regularly (at least every six months) – adjusting for alignment with your goals, not in response to the lure of market forecasts.

It’s far more reliable way to build sustainable wealth than relying on the promise of a treasure map.