‘Tis the season, as they say, for market “pundits” covering all manner of market to descend from on high to recap what transpired in 2018, and to share with us, their enlightened view of the road ahead in 2019. If you are sensing a tinge of sarcasm in the opening sentence, you are ahead of the curve.
I came across an article in Bloomberg recently that reminded me of the folly of market prognostication. The article revisits some of the forecasts we might have been exposed to a year ago and examines how accurate they turned out to be. It wasn’t pretty. Of course, with the benefit of hindsight, it is easy to poke fun at those who stepped out on a limb to make a prediction and were then proven to be wrong, and often spectacularly so. But surely there must have been someone who got it right, right? I’m sure there was, but no more than you would expect by random chance. In fact, research shows that those who have made accurate market forecasts in past time periods do not tend to be able to consistently do so in future time periods, implying more luck than skill is involved in the short-term and sporadic forecasting successes. Think about that for a second longer – if someone were able to accurately and consistently predict where the economy and markets were headed each year, why would they share that with us mortals? Would they not be better off carefully guarding that information for their own profit?
Understanding this begs a more important question: why do we continue to pay attention to market forecasts? There have been books written attempting to answer this questions, but in essence, I think it boils down to two fundamental truths:
1) Humans are hard-wired with a number of cognitive biases that lead us to believe we can predict an unknowable future… and, we really like a good story. Where financial markets are concerned we fall prey to recency bias (amongst a myriad of biases) – meaning we tend to extrapolate the most recent data point to infinity. Take Bitcoin at the end of 2017, which had been making spectacular gains, as case in point. A number of analysts, noted in the referenced Bloomberg article, predicted that Bitcoin would continue trending higher, with price targets ranging from $20,000 per coin on the low end, to $1,000,000 on the high end. Bitcoin today trades for approximately $3,400.
How is our predisposition to recency bias likely to influence our expectations of 2019? Given that 2018 is looking as though it will go out with a whimper, where markets are concerned, it might be easy to get drawn into a narrative of continued volatility, further market declines, and general doom and gloom. That story has momentum. We all like a good story, and so a forecast that follows what we already believe, is probably going to be, well, believable.
2) The second fundamental truth pertains to the investment industry more broadly. Because most people expect finance professionals to be able to do a reasonable job of predicting the near-term future (despite all evidence to the contrary), finance professionals are all too happy to give us what we want - demand is met with supply. Some experts use tenuous language when making their forecasts, and explain a few of the untold million different ways their forecasts could prove incorrect, or they give a range of potential outcomes wide enough to drive a truck through. Those are the good ones - they make for an interesting read, but ultimately do not provide us with any actionable insights. The bad ones make no such mention of their fallibility, issue precise estimates, and may lead an unwitting consumer of their “wisdom” to make potentially disastrous investment decisions should they prove incorrect. Be forewarned, it is easy to get drawn into a well written, articulate forecast written by someone with excellent pedigree and credentials. The old cliché is that such experts are “often wrong, but never in doubt”.
Alright, I have had my fun. I’m now going to turn my attention to providing some actionable advice. If we really are suckers for a good story, and the stories available to us are more frequently incorrect than correct, how can we possibly hope to be successful over the course of our (hopefully long) investing lives? The good news is that we do not need make investment decisions based on what we expect will happen in the next 12 months. Caveat: If you have a planned expenditure within the next few years, you should be budgeting for that now, and have cash (or cash equivalents) on hand, or a credit facility sufficient to cover that expense. Assuming near-term liquidity needs are planned for, we are now talking about investments with time horizons ranging from several years to several decades. When we switch from thinking about the next 12 months, to the next 12, or even 30 years, a lot of the short-term randomness we see over shorter time periods becomes less significant. We are free to instead consider factors that will actually make us successful investors, such as:
1) Adherence to an evidence and rules-based investment discipline. “Evidence-based” refers to an investment discipline that uses academic research (as opposed to baseless opinions, market timing and forecasts) to position a portfolio to give you the best odds of success over the long-term. “Rules-based”, means your investments are managed by a set of pre-determined rules, which are supported by the same academic research, and are adhered to come what may. Do you ever wonder how the most successful institutional money managers consistently outperform individual retail investors? This is the secret: they have a play-book, and they follow that playbook until they achieve success. They expect the unexpected, the volatile periods with lots of political drama and uncertainty, but they stay the course - they follow the rules they set for themselves.
2) Deciding on an appropriate asset allocation and risk tolerance. Your asset allocation should balance your need for income from your portfolio, even in a down market, with your desire to maximize returns over the long-term. Importantly, your asset allocation should lend itself to a level of volatility you can live with. It is no good to you to try to shoot the moon, if at the first sign of trouble you become panicked and sell. You must select an asset allocation you can live with in all market conditions.
3) Education. Financial markets can be confusing, frustrating, and downright scary if you do not know what you are up against. Take the time to understand how markets have performed over long time periods, or seek advice from someone who will help you understand what you should and should not pay attention to.
4) Discipline. I have touched on this already, but it bears repeating. None of this works without discipline. Educate yourself, or align yourself with someone who takes the time to explain markets to you, develop a rules-based investment strategy with an appropriate asset allocation, and stick with it. Free yourself from short-term forecasts that really do not matter anyway. Invest confidently for the long-term and expect a couple bumps along the way. You will be well rewarded if you do.