The Folly of Forecasts

The new year has arrived, which means hangovers, doomed resolutions to lose weight, and a host of forecasts from the gurus in the financial media. I’m not sure which will cause more suffering.

The attention investors give to market forecasts remains one of the great mysteries of human psychology. The evidence is overwhelming that no one possesses the ability to consistently call the direction of the stock market, bond yields, or currency rates. Yet every year the media invites experts to do what we know they can’t do. And every year investors listen to them, act on their recommendations and suffer the consequences.

One reason this is allowed to go on is that forecasters are celebrated when they’re right but rarely held accountable for their bad calls. So last year I clipped several articles that included forecasts for 2014 so we could evaluate how accurate they turned out to be.

Let’s start with Outlook 2014 by CIBC World Markets, which included the following forecasts for equities, bonds and currencies:

  • “US equities are hardly cheap given their run-up in 2013, but the Canadian market would appear to have more room to run … Within the equity market, what hasn’t played well in the past few years should now outperform. That includes equities tied to global growth rather than low interest rates, such as base metals and energy stocks.”
  • The yield on 10-year Government of Canada bonds will rise from 2.68% in early December 2013 to 2.95% by the end of 2014.
  • The Canadian dollar will strengthen modestly and the USD would end the year at about $1.05 CAD.

Swing and a miss, strike three. All of these forecasts were dead wrong: US stocks outperformed Canada again, thanks in part to a very strong US dollar that closed the year near $1.16 CAD. The sectors forecast to outperform were the biggest flops in an otherwise strong market: base metals (using the BMO S&P/TSX Equal Weight Global Base Metals ETF as a proxy) were down about 10% on the year, and energy stocks (based on the iShares S&P/TSX Capped Energy ETF) fell closer to 17%. And if you shortened your bond duration based on CIBC’s prediction of rising rates, well, that didn’t work out either: the yield on 10-year Canadas had fallen to 1.81% by December 30.

The worst of the rest

Next up: the Chief Investment Officer of Sun Life Global Investments, who shared his 2014 forecasts with Advisor’s Edge. He predicted the TSX would be in negative territory by the end of the year: “Stay away from Canada; we see a lot more headwinds continuing on.” Despite those headwinds, the broad Canadian market returned about 10% on the year.

The CIO went on to encourage investors to invest more in Europe and emerging markets (both lagged North America significantly in 2014), reduce their bond allocations (bonds had their best year since 2011), and declared that “dividend stocks will continue to pay off” (several popular dividend-focused ETFs in Canada and the US underperformed the broad market).

The forecasts from the US media were just as dismal. A survey of gurus by Business Insider resulted in a consensus forecast of 1,949 for the S&P 500 by the end of 2014: the index closed the year at 2,060, higher than all but one expert’s opinion. Over at the Motley Fool, investors were urged to shorten their bond exposure (oops, long bonds were up about 20%) and told that “Europe is particularly attractive” (for US investors, European stocks fell about 6%).

Tune them out

I don’t want to imply that these forecasters got everything wrong. On the contrary, some were dead on by predicting stable short-term interest rates, another strong year for US stocks, and weakness in commodity prices. Many others were half right—like those that got the direction right, but not the magnitude or the timing. But in any diverse collection of forecasts, many will turn out to be right simply by random chance. The lesson here is not that forecasts are always inaccurate: if they were, you could become wealthy being a contrarian. The point is that they’re worse than useless, as they are wrong far more often than they’re right. The only rational response is to ignore them all.

Instead of listening to the gurus this year, try a different tactic. Build a portfolio with a mix of stocks and bonds based on your ability, willingness and need to take risk. On the equity side, hold Canadian, US, international and emerging markets stocks at all times, and don’t try to guess which will be next year’s winner. With your fixed income, choose bonds or GICs according to your time horizon and your tolerance for volatility, not based on where you think interest rates will be next year.

So listen to the talking heads if you must, but remember William Bernstein’s advice in Rational Expectations: “Don’t even think about trying to extrapolate macroeconomic, demographic, and political events into an investment strategy. Say to yourself every day, ‘I cannot predict the future, therefore I diversify.’”

 

28 Responses to The Folly of Forecasts

  1. Mr. Captain Cash January 1, 2015 at 10:01 am #

    Thanks for putting this together. This is exactly why I plan to sticking with my investment portfolio of diversified index funds and rebalancing when funds become available. Best of luck throughout 2015 and thanks for providing such a great resource to answer the questions of the couch potato followers!

    Mr. Captain Cash

  2. Jake January 1, 2015 at 12:01 pm #

    Make a plan and stick to it is pretty much what people should do. I’m in process of rebalancing my portfolio and thought about putting less in canada than rest of world equity with the talk of lower oil and banks won’t do well in 2015. But have caught myself and won’t let the experts lead me down the wrong road which most do year after year with these awful predictions.

  3. Bob January 1, 2015 at 2:06 pm #

    When will you be publishing the 2014 returns on your various portfolios? I am interested in the results. Thanks

  4. Canadian Couch Potato January 1, 2015 at 2:20 pm #

    @Bob: In about a week.

  5. HeidiPG January 1, 2015 at 2:40 pm #

    Right on, Brother!

    Today being the first day of the year, I have deposited the annual max to our TFSA accounts and the RRSP account we will top up for the year. This cash was accumulated through monthly savings over 2014 by transferring to a holding account on paydays.

    I rebalance our Couch Potato Portfolios in June because that is our anniversary of starting them. I am NOT worrying about timing markets so it doesn’t hurt to sit as cash for a few months – money is there and available when I need it and the dividends continue to accumulate too.

    I will be talking to a financial planner to review our retirement plan this year, not for investment advice, rather to review our plan A, B and C depending on retirement ages. We are 55 and it is time to review our retirement options again.

    I love my couch potato portfolios. Started the first account in 2008 (weeks before the crash) and haven’t looked back despite the woes of the market. I stuck with it and the markets recovered – so did our portfolio. I don’t feel stress about making investment choices – I just keep to the plan and rebalance whether I have cash available or I am offside on my target percentages.

    The couch potato strategy works and my investment portfolios prove it!

  6. Robert_M January 1, 2015 at 5:42 pm #

    Dan,

    All the best in 2015 for you and your family.

    It has been two years since I took your advice and started the transition to an indexing portfolio. I have just 3 active funds remaining with DSC penalties attached. I should be completely DSC free in 1-2 years depending on whether or not I want to accept the DSC penalties.

    I have a better understanding of my portfolios now and have a better sense of security as I know that the funds track well understood indexes. With my active funds, there is always a sense of dread each quarter as I wait for the account statements to see how they did.

    For that peace of mind, I thank you.

    One of the things that I have come to realize is that at any given time, some person or portfolio strategy is doing better than me. I have to accept that and just go with the flow. Proper asset allocation, maximum diversity and low costs are the cornerstones of my new view on investing.

    When the downside hits, I understand that it is the bond portion of the investments that will keep us afloat and that is re-assuring in itself.

    So may 2015 be a banner year for you, and again my thanks for letting me see the light.

    cheers,

    rob…

  7. harveym January 1, 2015 at 8:01 pm #

    Great post. I often wonder which investors read this media forecast trash? Not everyone. DIY investors do it at their peril and need these types of posts to educate themselves. I know that clients of smart reputable financial advisors are counselled (yes, advisors need to do this) NOT to watch BNN or read financial sections of newspapers. William Bernstein books are a far better wiser read. So is the CCP :)!

  8. Canadian Couch Potato January 1, 2015 at 8:08 pm #

    @Robert_M: Many thanks for the kind words, and all the best to you as well. Market returns have been excellent for the last three years, and that certainly helps. But as you’ve pointed out, there is also a lot of comfort in simply understanding and being comfortable with your investment strategy.

  9. Lucius January 2, 2015 at 2:16 am #

    Thank you for a very interesting article.

    Years ago, I did research into the academic financial literature on predictions.

    1-It is impossible to predict interest rates, currencies or if shares will go up, and I never do so. But it’s not easy. By abiding by that rule, I accept to disappoint most people, to ‘look like a dummy’, because financial conversations revolve so often around predictions.

    2- yes, active management or stock picking are useless and diversification is the answer. This has been known for more than 25 years. I have avoided stock picking and been purchasing the index at a low cost since the early days of Vanguard. Again, there is a problem. For many years, I had the impression of ‘having ‘an edge’ over other investors,because I understood the futility of stock picking, and I was rewarded for going the index route. The problem is that in recent years, indexing has become mainstream with small and also large (eg: pension funds) investors. The new question is what happens when everyone buys the index? It’s a new phenomenon which has never existed in the history of finance, and I don’t know the answer.

    3- it is possible to successfully predict that some shares or country indices will go down. Years ago, I did research on short selling and tried it for a few years. Although I am not intelligent, according to my spouse, I found it easy to predict that some companies or countries (MSCI index of individual countries) were hugely overvalued. So why did I end up with zero gains (gains offset my losses, which means that I lost money in comparison to an investor in T-Bills, and a huge waste of my time). I came to understand that there many aspects to making predictions. I could predict that a share would go down, but was unsuccessful in predicting when. The problem is that irrational exuberance can last a long time, and it is therefore not possible to profit from short selling (because the financial instruments used have expiration dates). Look at how long Nortel shares remained in the stratosphere.

    4- to be fair, studies have shown that some types of predictions are statistically more ‘reliable’ (more often correct than tossing a coin), and should catch our attention. For example when stock analysts or even better rating agencies CHANGE their recommendation/rating, and DOWNgrade (not upgrade) a company or country.

    I look forward to your feedback on these issues.

  10. Edward January 2, 2015 at 12:25 pm #

    Great article to start the new year! I am constantly amazed when (in otherwise rational and professional) financial forums people say, “I feel US equities are at their peak,” or “I have a feeling that bonds will crash and burn”. “Feel”? They have a feeling and go with it? Others will often support their decision saying gut feelings are often correct. Hell, in my mind this is math–feelings don’t give you a correct answer, calculations do. There shouldn’t be any emotion involved at all when calculating numbers and percentages.

    Who would you trust with your math? A gypsy fortune teller or Mr. Spock? I’ll go with the Vulcan every single time.

    “My guess doctor, would be meaningless. I suggest we refrain from guessing and find some facts. Spock out.”

  11. Brent Mac Donald January 2, 2015 at 7:55 pm #

    Very interested in going the Couch Potato route

  12. CharlieF January 3, 2015 at 6:09 am #

    Are the model portfolios going to be updated too?
    Like changing it to VCN+VXC+VAB to keep it really simple?
    And keeping a VCN+VUN+XEF+VAB to provide more diversification?

    I feel like there should be a section under model portfolios that factor in taxes too.
    Like keeping VAB in TFSA, VXC in RRSP, VCN in NR. Then use Horizons when TFSA/RRSP are maxed out.

  13. Canadian Couch Potato January 3, 2015 at 9:14 am #

    @CharlieF: Model portfolios will be updated this month.

  14. CharlieF January 3, 2015 at 10:38 am #

    Thanks!

    Going back on topic, I think in order to drive home the point of speculating/forecasts is finding ones that are correct and following them when they predict it a second/third time.
    Because guessing up/down magnitude with its cause is pretty easy. But guessing up/down consecutively is near impossible and that’s what people what to hear from the ‘experts’.

  15. harveyM January 3, 2015 at 3:10 pm #

    @CCP
    Your advise: “Build a portfolio with a mix of stocks and bonds” following your model portfolios is very useful for most accumulation phase investors. Your
    Model Portfolio Performance 1994–2013 data substantiate the good returns. The advise has the usual caveat of investor risk analysis which for de-accumulation retirees is a sensitive issue. Most can’t handle the volatility of a 60/40 portfolio! What becomes important for retirees is req’d rate of return and what would be useful for such DIY retiree investors is to have data for your portfolios that give a rate of return based on a more conservative asset allocation mix such as perhaps 20/80 such that they can fine tune their portfolios to match what they really require.

  16. Craig January 4, 2015 at 2:42 pm #

    Hi Great website!

    I am interested in the couch potato but I am trying to determine a reasonable rate of return for this portfolio. I noticed you had created the model portfolio performance with annual percentages for 3 to 20 year periods. I was wondering if those percentages are just an average for the years in the periods being considered or did you take the future value at the end of the period and convert that into an equivalent compound interest rate?

    http://canadiancouchpotato.com/wp-content/uploads/2014/01/CCP_Model_Portfolio_Performance_1994-2013.pdf

    When I was playing around with it you can have a different of up to 1%!

  17. Canadian Couch Potato January 4, 2015 at 2:59 pm #

    @Craig: The historical returns of the model portfolios are annualized and assume that the portfolio is rebalanced annually at the beginning of the year. I’m not sure what you mean by “playing around with it.”

    As always, please understand these returns are hypothetical and historical. They tell you nothing about what the portfolios will return in future years.

  18. Craig January 5, 2015 at 9:53 am #

    @Canadian Couch Potato

    Yes I realize that past performance does not guarantee future performance…

    Are you implying that the chart you provided is meaningless? Or does it serve to show what the past performance was of the couch potato system?

    What I would like to know is whether for example the 20 year performance number of 7.3% how did you you determine this value? Did you simply take the average of each year’s performance for 20 years to come up with the 7.3%? Or did you look at the total amount after 20 years and calculated a compound rate based on the initial investment.

    By playing around with it I mean depending on which way you determine the annual percentage can cause the rate of return to change by 1%. If you determined the 7.3% is just the average value for 20 years, an approximate compound rate of return would be around 6.3% (I don’t have the exact data). Your chart doesn’t state whether the annual percentage rate is simple (no compounding) or effective (includes effects of compounding).

  19. Canadian Couch Potato January 5, 2015 at 10:04 am #

    @Craig: The model portfolio returns are not meaningless: they’re just not predictive. Expected returns going forward are likely to be lower, given that the 20-year performance of bonds is unlikely to be repeated.

    The returns represent the compound annual growth rate, which is what you describe in your second example, i.e. the difference between the initial value and the final value annualized over 20 years. The simple average (or “arithmetic return”) is meaningless when reporting investment returns.

  20. Gpete January 5, 2015 at 12:32 pm #

    I might suggest to Brent that if you are interested in starting up the Couch Potato route that you begin with a portion of your savings. Say a third, or a half,and you will learn a lot. I believe you will love it and can then make the best decisions for further ETF investments in confidence.

  21. oldie January 5, 2015 at 4:12 pm #

    @Edward:

    “My guess doctor, would be meaningless. I suggest we refrain from guessing and find some facts. Spock out.”

    LOL! This should be printed at the top of our portfolios, to remind us of our original plan when we want to tinker.

  22. J from Ottawa January 7, 2015 at 12:50 pm #

    Your website offers sage advice that I have come to value very much but I don’t know if you aware on this same article where you caution following mixed forecasts you have an add running titled ‘Man Turns $300 into $100K’ and it leads to a sales site where they are selling some get rich quick formula. A bit of a mixed message there.

  23. Canadian Couch Potato January 7, 2015 at 2:16 pm #

    @J from Ottawa: Thanks for the comment. Unfortunately publishers have no control over what ads are served by Google (though I can, and frequently do, block the worst ones). Keep in mind also that every user sees different ads, so your experience is likely different for others.

  24. Tyler January 7, 2015 at 2:46 pm #

    Tuning out the talking heads is great advice, I totally agree! Thanks for putting in the effort to give us yet another reminder not to get caught up in short-term hype and just stick to our long term plan. I’ve been growing my little “potatoes” for a few years now and am quite happy with the results so far. It keeps things simple and doesn’t take up too much of my time. Your posts are a pleasure to read, keep up the good work in 2015!

  25. RW January 7, 2015 at 8:52 pm #

    Looking forward to model portfolio updates. It is my news year’s resolution to jump in this year into a proper couch potato strategy after doing it half-assedly for a decade. All of my assets are currently in cash, waiting 🙂

  26. Ravit January 30, 2015 at 1:35 pm #

    Big thanks for putting this together, very informative. No one can really know the future realistically speaking. Also I would suggest looking at Gile Cadman’s take on the financial market, check him out: http://gilescadman.com

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