I’m confused by a lot of things in investing, but the enduring influence of market forecasts is the one that stumps me the most. Year after year, expert predictions, estimates, forecasts and projections prove to be profoundly wrong. And yet next year we seek them out again. It’s like repeatedly pounding your thumb with a hammer and expecting that at some point it will stop hurting.
One of the reasons we still listen to forecasts is that the media love to celebrate the few that turn out to be right. Those that are wrong—which are the vast majority—are rarely held accountable.
With that in mind, I thought it would be interesting to look at the 2011 Fearless Forecast, the latest edition of a report published for 20 years by Mercer. The Fearless Forecast compiles the consensus opinions of Canadian and global investment managers regarding the capital markets and the economy. The 2011 edition included input from 56 investment management firms, including some of the most prestigious asset managers in the world.
The last shall be first, and the first shall be last
The managers were asked to identify which asset classes they believed would be among the top and bottom performers in 2011. The most popular picks in each category are listed below, along with the percentage of managers who predicted that asset class would be among the best three and worst three performers. Where it was available, I’ve also included their average estimate for the returns of that asset class, followed by the actual index return for 2011.
| Asset class | Best | Worst | Forecast | Actual |
| Emerging market equities | 63% | 4% | 10.6% | -16.3% |
| US equities | 43% | 4% | 9.1% | 4.4% |
| Canadian equities | 37% | 6% | 8.4% | -8.7% |
| EAFE equities | 29% | 2% | 8.1% | -9.7% |
| Canadian small-caps | 29% | 4% | 9.5% | -14.4% |
| Canadian long-term bonds | 4% | 66% | 0.1% | 18.1% |
| Global bonds | 2% | 49% | – | 9.0% |
| Canadian bonds | 4% | 47% | 1.1% | 9.7% |
| Cash | 6% | 47% | 1.4% | 0.9% |
| Real-return bonds | 2% | 32% | 0.9% | 18.3% |
| Real estate | 2% | 23% | – | 21.7% |
It should be clear from the above table that the forecasts were not merely useless: they were spectacularly harmful to anyone who acted on them. An investor who followed these consensus opinions would have been slaughtered in 2011. They would have been helpful only to the strict contrarian: if you shorted all of the top picks and leveraged all of the bottom picks you would have made out like a bandit.
Dissecting the sectors
Let’s go one level deeper and see how the experts made out when forecasting the performance of individual sectors of the Canadian economy. After all, active managers know when to get defensive during difficult markets, right?
Below is the percentage of managers who picked each sector as one of the best or worst performers, along with the actual 2011 return for that sector. (I was not able to find index data for the other four sectors—industrials, consumer discretionary, telecom and health care—but none of these make up more than 6% of the economy.)
| Asset class | Best | Worst | Actual |
| Energy | 62% | 0% | -14.8% |
| Materials | 47% | 17% | -21.2% |
| Financials | 23% | 26% | -3.9% |
| Technology | 21% | 6% | -20.1% |
| Consumer Staples | 6% | 38% | 6.8% |
| Utilities | 4% | 40% | 6.5% |
The message here is not that these investment managers are fools. On the contrary, the participants in this survey are among the smartest folks around. They have a deep understanding of the markets, and access to more data than you and I will ever have. The point is that their superior knowledge and skill give them absolutely zero ability to predict what’s ahead. Their predictions were far worse than you would expect from random chance.
Human beings take comfort in forecasts because we detest uncertainty. But if you’re going to be a long term investor, you need accept that uncertainty is part of the deal. Since we can never be sure of what lies ahead, the most prudent strategy is to diversify.
All of the asset classes in the table above have positive long-term expected returns, but all of them will behave unpredictably over the short term. Rather than engaging in the futile attempt to guess next year’s winners and losers, hold all of them in your portfolio all the time. Rebalance once or twice a year. And make a pact never to listen to market forecasts again.
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None of them predicted any drops in any sectors? That’s another bias of the forecast industry, always drumming up good returns to get more people to invest.
@Slacker: The report does not include their specific return prediction for each sector. They were just asked which would be the best performers and which would be the worst. The figures in the table are the percentage of managers who identified each sector as one of the best or one of the worst.
But your point is well taken: most forecasters err on the optimistic side for self-interested reasons.
This same nonsensical behaviour occurs in the sports media world when commentators predict the scores in upcoming games. It’s one of their most annoying habits (alongside picking winners). Doc Zone aired a worthwhile documentary called The Trouble with Experts. “In the recent stock meltdown, we discovered that some of our most important experts – our financial gurus – didn’t know much at all. So what about all the other experts out there?”
http://www.cbc.ca/doczone/episode/the-trouble-with-experts.html
@Chad: Thanks for the comment. I would also recommend David Freedman’s book Wrong, which makes much the same argument. To me, what’s fascinating is not that experts keep making predictions—they have a vested interested in doing so. The real curiosity is that we keep listening.
http://online.wsj.com/article/SB10001424052748704122904575315222129011504.html
Your point is totally valid and you make it clearly (as always) and it is one of the reasons that I have bought into the couch potato philosophy myself.
However the couch potato philosophy is based upon the fundamental that the markets are efficient and are reacting to every piece of information out there. It is the very same people who made these forecasts that make our markets efficient so while their crystal ball may not be perfect there is value in the analysis.
I’m curious to know how a strict contrarian investment strategy would actually have worked out going back X amount of years (rebalanced each year of course, at forecast time!).
@J: It’s true that passive investors rely on active investors to keep markets efficient, so we should be grateful to them on that level. But we can still ignore their forecasts. :)
@Pat: My guess is that doing the opposite of everything the experts suggest would have worked out very well—though I wouldn’t recommend it!
I think an interesting ETF idea is an equal-weighted fund of the 5 most hated asset classes for the next calendar year, rebalanced annually. It might be an interesting, uncorrelated addition to one’s investment portfolio.
Andrew F
You could backtest your idea.
I do not use forecasts but do use scenarios to stress test a portfolio. They inform several things:
How the portfolio responds to the scenario – you know what you own and its correlations better
How to anticipate regret given your asset allocation. This allows one to stay the course better.
I use the above to do minor tactical asset allocation toward value which is in a way similar to what Andrew F is talking about. It is really a form of rebalancing but with a value bent.
@Andrew: What kind of scenarios do you consider? Do you ask, for example, how the portfolio might perform if interest rates rose 1%, etc? There are some dangers here, I suppose, but if this allows you to be more confident with your asset allocation and more likely to stay the course, then that’s a good thing.
Once you accept the fact that the market is random in the short term, life gets a whole lot easier and your success as an investor increases. Realizing that the experts cannot time the markets makes it easier to admit to yourself that you cannot either. Thanks for the article, and the encouragement for the passive investing rationale Dan.
It is interesting to see that in a topic on why we can’t beat the market, almost half comments are based on how we can beat the market with this knowledge ;).
I always tell myself : if I as an amateur enthusiast can make positive alpha return, a smart senior investor for a large bank would’ve picked up on it times before me and acted on it with such capital such that the profit opportunity erodes.
As far as public figures giving or selling advice I rationalize: If they really got it right, and could make an excess return of .5% structurally.. they would’ve been hired by large fund managers for mega amounts of money & they certainly wouldn’t show up on TV giving free advice.
These 2 facts keep me clear from wanting to beat the market, or being tempted by advice or reports of out performance by ‘experts’.
While markets might be inefficient up to a certain point, we as small time investors could never benefit from it. Like we can’t make profit of arbitrage opportunities because of lack of capital and execution speed/ease.
So be happy we get optimal return for the risk we take, by being able to fully diversify away all company & country risks with cheap ETF & mutual funds.
@Dean and Frank: It’s great to hear you say that you find comfort in ignoring these expert forecasts. Many investors seem to take comfort in them, but I agree with you: I only felt liberated after accepting the fact that they are worthless. It has allowed me to concentrate on the things I can control: how much I save, how much risk I want to take, how much I lose to fees and taxes, etc.
Wow!! These numbers are very telling. Almost a perfect negative correlation.
My wife tells people that she has no sense of direction, whereas in fact she has a very good sense of direction – 99.9% of the time she turns exactly the WRONG way.
Sounds like our financial advisors might be plagued with the same malady.
I’ve given up trying to change my wife; no matter how aware she is of the problem and the negative correlation, she almost always gets it wrong. So, whenever we go somewhere new, she sticks close by me. Again, the analogy applies – we’re never going to change the financial advisors.
@GeoEng51: I hope for your sake that your wife doesn’t read this blog. :)
Ah…she’s good with it. She’d just laugh if she saw it :>)
I personally assume that the market will do whatever it wants to do, no matter what anyone wants or says.
My other assumption is that if I pick good companies that can make money over the long term, I will do ok over the long term.
I agree that it has been proven that nobody can beat the market….but why not? In every other profession the cream rises to the top. There are top athletes, doctors, lawyers, scientists, authors, etc. The NHL has the best 600 hockey players in the world. You can put these guys on the ice with any group of people and they are going to win (as long as they are not playing against each other). How can there not be a top investor? Are there more variables than the human brain can comprehend? Is it the irrational nature of people? Is the market too large? Is the market rigged? Is the information unreliable? Whatever the reasons I find it hard to believe that no one has figured it out!
@SPBrunner: Thanks for stopping by. It’s true, by taking a long-term view, all of this short-term forecasting quickly becomes irrelevant. And if you have a shorter time horizon, it makes more sense to focus on adjusting your asset allocation based on risk exposure, not on where you expect the markets to go.
@Elmer: You ask an excellent question. There is no question that there are many people who understand financial markets better than you and I do, and that they may have access to better information. The key insight here is that this superior knowledge and skill do not allow them to forecast the future, because markets respond dramatically to surprises, which by definition cannot be known in advance.
The analogy I like to use is the weather. A meteorologist knows more about weather systems than you or I ever will. She may understand the physics and chemistry of what’s going on in the atmosphere with great precision. But that does not mean she can tell you whether next winter will be colder than average, or whether it will snow in Edmonton three weeks from now.
The markets, like weather systems, are extremely complex, with so many unpredictable elements that no one can possibly account for all of them. Instead of trying to guess whether it will be sunny or rainy in the markets next year, it makes sense to build a diversified all-weather portfolio what will stand up to anything.
@Elmer
Part of the reason is the expenses incurred in active management. An investor not only has to beat the market but has to beat the market after expenses. In other fields of endeavour, working harder and doing more will accomplish more and will help get you to the top, whereas in investing all that extra effort has to be accounted for. It adds expenses that lower your rate of return.
I think to do well in the market, using common sense really helps. Also, do not invest in what you do not understand.
I also do not think that investing has to be a contest. If you are getting a reasonable return with investments that let you sleep at night, I think you are doing a good job in investing.
I keep coming back to this topic and thinking about it. This research is obviously flawed for multiple reasons.
But let’s say that a 60/40 bond/stocks portfolio outperforms the risk/return statistics of a super hedge fund. What does this tell us about the performance of the hedge fund?
Absolutely NOTHING. Hedge funds don’t follow Normal returns, so stdev as a risk measure doesn’t tell you anything. So Even the most commonly used risk&return measures and their performance (sharpe ratio) tell us nothing about hedge fund performance. Why should these results which are by far simpler tell us something?
Next to that, as stated in this article/comments… in order to have an efficient market (the base assumption of ‘couch investing’) we need professional investors to trade with each other and valuate the companies at efficient pricing (for every transaction 1 person needs to be wrong). Hence there IS profit = alpha return to be made. While it is hard to attain as private investors, it is there.
It is too easy to say we do better than hedge funds by passive index investing etc. While it may be a comforting thought, I know this for myself, it is also making you blind & preventing you from reaping profits that are out there.
I think superior returns can not be achieved because of greed. People do not possess the patience required to make disciplined decisions. For instance I own a stock right now that has run up 25 percent in the last month. This stock is a long term pick however it does not pay a dividend. My instinct is to sell, however I fear missing out on further price appreciation. When i purchased the stock i would have happily taken a 25 percent gain over the next several years. now that it is there for the taking I question my original target. I must be an idiot to think that this stock is going to run away and never come back. If it does then who cares, I own a lot of other good products. I should count my blessing and sell. We eventually sell every product in our portfolio so why are we so afraid to take profit. Instead I will hold the stock until it settles back to my original purchase price and claim that I am in it for the long haul. Really? Please excuse my typing as I am on an Ipad.
Thanks for providing the numbers, always good to look back and test accuracy.
To me this suggests a few conclusions:
1. The indicators they look at aren’t indicators at all (much like the difference between correlation and causation, which can cause a myriad of problems when confused) and implies it’s important to look for other indicators
2. Specific predictions can often prove troublesome, which suggests invest for the long term rather than the short term (in fact money churn is one of the greatest killers of profits)
Beneath this though are I think some fundamentally flawed assumptions. For example, the assumption that predicting the performance of higher performing asset classes is important at all. The reality is there’s too much focus on yourself relative to the market. The question isn’t “did I pick on the best asset classes?”, the question is “did I consistently achieve positive net rate of return after taxes, fees, and inflation?” If you achieve this every year you’re pretty likely to beat the market overall and even if you don’t who cares? You made money. It is chasing the money you didn’t make that gets people into trouble.