Forecasters are bad at forecasting

Over the past three decades, the accuracy of three day weather forecasts has remained basically unchanged. However, despite the improvements in computer processing power, seven day temperature forecasts are still only correct 5% of the time1. But this doesn’t stop us looking at the seven day outlook when we start packing for our holiday which is one week away.

Over 50% of investors with their own self-managed super fund turn to the media for guidance with their investment decisions. On 19 December 2011, well respected journalist Alan Kohler – note he’s not an economist or even licensed to give advice – said on the ABC 7pm news that “I believe the conditions are in place for another major panic sell-off on the share market…on Monday I will be significantly reducing my already reduced exposure to equities to possibly zero”.

Since that report went to air, the Australian stockmarket has risen by 26%.

Alan was relying on his personal conclusion on the possible outcome of events which, by their very nature, are uncontrollable. How can anyone factor in expectations of economic growth, corporate revenues from various sectors, employment, climatic occurrences, changes in government policy, international economic and political influences and psychology into an assured forecast?

It is well documented that we, as investors, have inbuilt biases to consistently make decisions that are not necessarily in our best interests. In fact, Daniel Kahneman was awarded a Noble Prize in 2003 for making this seemingly obvious statement! When faced with a risky decision, we typically allow emotion to overwhelm reason.

Some examples of our inbuilt biases include:

  • Overconfidence – most people think they are smarter than others, meaning the decisions they make are better than the average person.
  • Hindsight bias – events appear obvious after the fact, therefore many think the future must also be predictable.
  • Extrapolation – we rely too heavily on recent facts to make decisions on our future.

These natural, human biases that have evolved over time form part of our survival instincts. But they can easily turn any of us into a bad investor.

Many people fret about investing in the stockmarket, primarily because of opinions or predictions they hear from economists or stockbrokers in the media. They know they’re investing to provide themselves with income over the next 30 years or longer, yet the 24/7 information cycle we live in means they can’t help but shift their focus from the long term to what their investments are going to do tomorrow.

Below is the front page of the Australian Financial Review from 2 July 2012. The headline “Low returns shape as the new normal” would instinctively make many investors feel anxious about their share portfolio. The article actually says that “we are heading into a financial year that might well deliver a third year of negative equity market returns”. There is even “Expert Commentary Inside”.

Financial Review  

The actual result?

For the 12 months to 30 June 2013, the Australian stockmarket was up 22%, Australian listed property was up 23% and International shares returned 33% for an unhedged portfolio and 22% for a hedged portfolio. These returns were approximately double the long term averages.

In contrast, moving your funds out of shares and into cash would have returned around 3%.2

Not only was this headline on Australia’s major financial newspaper on the first business day of a new financial year completely wrong, but a new study shows the rate of mistakes made by forecasters is almost the only predictable thing about this whole senseless guessing game.

The research team at Goldman Sachs has analysed the magnitude and direction of “surprise” in the release of all US data since 20073. The level of “surprise” is the difference between the consensus expectation of economists polled by Bloomberg and where the indicator actually fell.

The study found that the forecasts tend to underestimate the outcome for several months in a row, and then overestimate it for several months in a row. In other words, if the forecasts were overly pessimistic in one month, they’re more likely to be overly pessimistic the next month, as well.

 

That’s surprising, because you might expect economists to adjust their forecasts based on being wrong the last time. Instead, they seem to think they were still close to right, until they finally change their minds and overcompensate in the other direction.

The study is really just an interesting window into how people who are supposed to be experts at telling us where the economy is going aren’t actually very good at it. There is no proven, market-predicting model hidden in a computer.

We would like to be able to consistently and accurately pick the best times to buy and/or sell, at the bottom and top of the cycle respectively. No one can.

We would like to be able to consistently and accurately pick the best investments. No one can.

The facts remain the same. Over time (think 10, 15, or 20 years), stocks typically do better than bonds, and bonds typically do better than cash. Low expenses are typically a good sign of future relative performance. We also know that a diversified portfolio will help protect you from the variability of the stock market.Over the shorter term, it’s just a worthless and distracting guessing game.

It is quite normal to have some degree of anxiety when investing in the stockmarket. The stockmarket is and always will be a relatively volatile environment in which to invest your funds. It is irresponsible to think otherwise.

If forecasting is so inaccurate when dealing in growth assets, what should you focus on?

The answer is free markets and the positive aspects of capitalism. With capitalism, there has to be a positive rate of return as companies cost of raising funds is equal to their investors expected rate of return. That proposition has not changed in over 100 years. In fact, the famous Scottish philosopher Adam Smith was the foundational father of free markets and capitalism when he wrote The Wealth of Nations in 1776.

In summary, there are three simple strategies you can employ in partnership with your trusted adviser to help ensure your emotions don’t overwhelm reason:

  • Understand how much investment risk you need to take to achieve your lifestyle and financial goals, and adjust your asset allocation over time as your required investment return changes.
  • Aim to keep between 5-10 years of cashflow invested in high quality, liquid bonds to reduce the likelihood of needing to sell a grow asset like a share at a distressed price.
  • Monitor your progress against your plan over time so you know if you are on track or not. This empowers you to make sensible decisions.

1 – Market Forecasting Isn’t Like the Weather, NY Times, Carl Richards, 17 June 2013.
2 – Source: Returns Program for 12 months to 30 June 2013. Indices used were ASX 300 Accumulation Index, ASX 300 REIT Index, MSCI ex-Australian World Index and MSCI World Index (hedged).
3 – Forecasters are bad at forecasting, study finds, The Washington Post, Lydia DePillis, 8 August 2013

Author: Rick Walker

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Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.