The Value Of Predictions

As we close out 2015, we find ourselves in one of the most comical parts of the year in finance.  The time to make predictions for 2016. Why is this comical?  Because Wall Street strategists are usually spectacularly wrong, yet investors still seem mesmerized by what they will say.  Wall Street strategists are not dumb.  There is no career risk in saying that the S&P 500 is going to go up 8 or 10% in a year.  Since that is the long-term average, you aren't really going out on a limb making this prediction.  No one is going to crucify you for it.  While you won't lose your job, you almost certainly won't be right.  In a recent article on MarketWatch 10 leading analysts are predicting a 6% gain for the S&P 500 next year.  Last year, these same analysts were looking for approximately 10%.  In fact, when you go back and look at analyst predictions, you will always see they predict returns in the upcoming year to be around 6 to 10%.  Let's take a look at the distribution of returns of the S&P 500 over the last 89 years to see what actually tends to happen:

Return distribution

We see that returns will be between 0 to 10% less than 15% of the time!  Here are some staggering statistics to consider as you ponder the validity of predictions:

  • Annual returns between 10 to 20% have been 46% more likely than annual returns between 0 and 10%
  • You've had the same odds of annual returns being between -10 and 0% versus 0 and 10%
  • It has been slightly better odds of generating annual returns between 30 and 40% versus 0 and 10%
  • 58% of all years measured (1926-2014) saw returns greater than 10%
  • 27% of all years measured (1926-2014) experienced negative returns

Rarely are returns average over a one-year period.  They have a tendency to be either much higher or lower than what analysts predict.  Given that analysts are probably right around 15% of the time (based on the frequency of returns above) it is hard to comprehend the value these predictions create for investors.  Maybe it's time to start realizing that the value of predictions is not for you, but the Wall Street firms (by selling you products) and the media (by you clicking on articles).  

Stock Picking Is A Losing Bet

Many of us at Greenspring used to be in the stock picking game.  It was really hard.  While our experience may have been anecdotal, there is new evidence coming out to support the idea that stock picking is a low probability strategy.  The Value Walk blog has posted a very interesting study on this topic.  Here are some of the major findings:

  • Since 1983, the US stock market has consisted of 8,054 publicly traded stocks (including delisted stocks)
  • 39% of stocks since 1983 have lost money
  • 64% of stocks underperformed the Russell 3000 during their lifetime
  • 18.5% of stocks lost at least 75% of their value over their lifetime

If you are keeping track at home, that means that you have a 1 in 3 chance to pick a stock that outperforms the index.  When I first read these statistics, I was astonished.  I figured that it should be about a 50/50 chance, since half the stocks should outperform and half should underperform.  The data tells us something different.  What we find is there is a very small contingent of stocks that have HUGE returns, while nearly 2/3rds failed to keep pace with the index.  To put it another way, index returns are significantly influenced by just a small group of winners.  If you don't happen to have some of these winners in your portfolio, you have a high probability of underperforming.  Here is a really interesting chart:

ind stock vs index

The chart shows that only about 6% of all the stocks significantly outpace the index, but they have a huge influence on the overall returns of the index.  What is the chance that you will be able to pick one or more of the stocks?  In looking at it from an attribution standpoint, it is even more astonishing. 25% of the stocks in the US over the past 30+ years have accounted for ALL of the gains!

attribution

When you start to understand the math and statistics behind stock picking, it should become increasingly clear that owning the entire market is a much safer and prudent strategy than trying to concentrate your bets.  

 

Being Diversified Means Always Having Something To Complain About

We've all heard it before:  don't put all your eggs in one basket.  Intuitively, it makes sense.  If we concentrate our assets in one area we will have a lot of problems if that area does poorly.  Therefore, if we spread things out, the risk of significantly underperforming is mitigated.  This is not a new concept.  King Solomon, who is considered one of the wisest men to ever walk the earth, preached this strategy 3,000 years ago.  In Ecclesiastes he wrote, "Divide your portion into seven or even eight for you do not know what mistfortune may occur on earth."

This all makes sense in theory.  But it is hard to implement and stick with a diversified strategy over time.  Why?  Because you will always have a number of asset classes in your portfolio that are underperforming.  It will be tempting to "sell the losers".  The last few years are a great example of this.  A diversified portfolio has significantly underperformed the S&P 500.  The simple fact is a diversified portfolio will ALWAYS underperform the best performing asset, since diversified nature of the portfolio will normalize the return somewhere between the best and worst asset class.  Today it is even more difficult because the asset class you see all the time (CNBC, internet, etc) is the one that is doing the best, and therefore, the one all diversified investors are trailing.

Below is a chart of the best and worst performing asset classes from 2006-2009:

diversification chart

One thing to notice is the difference between the best and worst asset class each year.  In most cases the delta is in excess of 50%.  The other thing to notice is how there is no pattern to discern what is going to be the best, or worst, investment in a given year.  As an investor, if we choose a diversified portfolio we have to give up the fantastic gains we could experience by putting all our money in the best asset class in order to avoid having all our investments in the worst one.  For most of us, this is a worthwhile tradeoff.  You just always need to remember that when you are properly diversified you'll always have something to complain about.

 

Predictions Are Worthless

I am not sure what our fascination about predictions are all about.  Whether it is political elections, sports, or the financial markets, everyone seems to be willing to stop and listen to someone who is willing to make a prediction.  Rarely do we ever go back to evaluate how those predictions pan out.  With regards to investment predictions, every once and a while I like to go back and check the accuracy of those prognosticators against the investment markets to see how they have held up.  One of the most famous is Jeremy Grantham, founder of GMO, a multi-billion dollar asset management company.  He periodically publishes a 7 year market prediction and gained quite a bit of notoriety for accurately predicting much of the investment returns in the early part of the 1990s.  As we approach the end of his 7 year forecast from June 30, 2008, I thought it would be helpful to evaluate his predictions (caveat- the index returns go through 5/31 while the GMO forecast is through 6/30):

Asset Class Index GMO Forecast Actual Return
US Large Cap Stocks S&P 500 3.2% 9.85%
US Small Cap Stocks Russell 2000 2.1% 10.46%
Int'l Large Cap Stocks MSCI EAFE 5.8% 2.42%
Int'l Small Cap Stocks MSCI EAFE Small  6.2% 5.69%
US REITs DJ Select REIT 2.7% 8.4%
Emerging Mkt Stocks MSCI Emerging Mkts 6.8% 1.25%

So, if you had taken GMO's advice and overweighted the areas they predicted would perform the best, you would have put most of your money in emerging market stocks and international stocks.  The asset classes where they predicted the worst performance (US stocks and REITs) have been the best places to invest.  The point is, no one has a crystal ball.  Those that have been right in the past have no better chance of being right in the future.  Once you realize this, you'll be a much better investor, immune from the siren song of predictions.  

Prediction Time!

It's that time of year again…prediction time.  Economists, wall street strategists and pundits have started coming out of the woodwork telling you where to put your money in 2015.  One thing they won't tell you is their track record from last year (unless it was good). One of the overwhelming areas that wall street hated last year at this time were bonds.  In a poll done by Bloomberg about a year ago, 72 out of 72 economists predicted interest rates to rise and bond values to fall.  72 out of 72!  With that amount of conviction, they have to be right.  Blackrock did something similar with all the major investment/research firms.  Again, everyone was underweight bonds.  Click below to see the graphic from their report:

consensus

You can guess what happened next.  World stocks (MSCI ACWI) were up 6.72% through 11/30 while long-term treasury bonds (Barclays Treasury Bond Index Long), the asset class that would have gotten hit hardest if these pundits were right, were up 21.59% for the same period.  Predictions may be fun to watch, but you should never make investment decisions based on them.  This is just more evidence that no one knows the future.  

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.