Economic and investment forecasts are often seen as central to investing, but should be treated with caution. The key to successful investing is to respect the market, have a disciplined process, be flexible and check your ego.
Introduction
As an investment strategist and economist I am regularly called on to provide forecasts for economic and investment variables like growth, interest rates and the share market. These usually come in the form of point forecasts as to where the variable that is being forecast will be in say a years time or its return over the same period. Such point forecasts are part and parcel of the investment industry.
There is no denying the usefulness of such forecasts as a means of communication but, as someone whose broader responsibility is the performance of a set of diversified funds (i.e. funds that have exposure to a whole range of assets like cash, bonds, property, equities and private capital), I have to recognise they have their limitations. In fact, it leads me to a broader issue. This is that there is often a big difference between being right (ie, getting some sort of forecast right) and making money. My reward comes from making money for our clients, not being right.
Forecasting is hard because it concerns the future
Jokes about economic forecasts are plentiful. At risk of being thrown out of the “economists club” here is a list:
· Economists were invented to make weather forecasters look good;
· An economist is a trained professional paid to guess wrong about the economy;
· An economist will know tomorrow why the things she or he predicted yesterday didn’t happen;
· Economic forecasting is like trying to drive a car blindfolded and following instructions from a person who is looking out the back window;
· Economics is the only field in which two people can share a Nobel Prize for saying the complete opposite;
· Economics is only useful for keeping economists employed; and
· There are two classes of forecasters: those who don’t know and those who don’t know they don’t know (J.K. Galbraith).
Surveys of economic forecasts are regularly compiled and published in the media. It is well known that when the consensus (or average) forecast is compared to the actual outcome, it is often wide of the mark. This is particularly so when there has been a major change in direction for the variable being forecast. This applies not only to economists’ forecasts for economic variables, but also to equity strategists’ share market forecasts and share analysts’ forecasts for company profits.
More broadly there are numerous examples of gurus using grand economic or financial theories – usually resulting in forecasts of “new eras” or “great depressions” – who may get their time in the sun but who also usually spend years either before, or after, losing money. For example, the gurus who foresaw a “new era” in the late 1990s looked crazy in the bear market earlier this decade. And many of those who thought global share markets in the late 1990s were in a bubble started selling way too early and in most cases have missed out on the rally over the last three years.
Psychology and forecasting
Forecasts for economic and investment indicators are useful but quite clearly need to be treated with care:
· Like everyone, forecasters suffer from numerous psychological biases including the tendency to assume the current state of the world will continue, the tendency to look for confirming (and not contrary) evidence in new information, the tendency to only slowly adjust forecasts to new information and excessive confidence in their ability to foresee the future.
· Quantitative point forecasts convey no information regarding the risks surrounding the forecasts.
· They are conditional upon the information available when the forecast was made. As new information appears, the forecast should change. Setting an investment strategy for the year based on forecasts at the start of the year and making no adjustment as new information arrives is often a great way to lose money.
· When it comes to investment management, what counts is the relative direction of one investment alternative versus others – the precise point at which they end up is of little consequence.
· More broadly, forecasting investment market variables, like share markets and exchange rates, is particularly difficult. Apart from trying to predict the variables that will drive the market, the forecaster needs to work out what is already factored in. On top of this, rules of logic often don’t apply in investment markets. The well-known advocate of value investing, Benjamin Graham, coined the term “Mr Market” (in 1949) as a metaphor to explain the share market. Sometimes Mr Market sets sensible share prices based on economic and business developments. At other times he is emotionally unstable, swinging from years of euphoria to years of pessimism. But not only is Mr Market highly unstable, he is also highly seductive – sucking investors (and forecasters) in during the good times with dreams of riches and spitting them out during the bad times when all hope seems lost. Trying to get a handle on all that and presenting it as a precise forecast or even as a grand market call is not easy. As John Maynard Keynes once observed: investment markets can remain irrational for longer than you can remain solvent.
In the quest to be right, the danger is that clinging to a forecast will end up losing money. James Montier, an equity strategist at Dresdner Kleinwort Wasserstein quotes 6th century BC poet Lao Tzu who observed “those who have knowledge, don’t predict. Those who predict don’t have knowledge”.[1] While this might be taking things a bit too far, it does sum up the difficulty of forecasting.
Why are forecasts treated with such reverence?
So why are forecasts seen by many as central to investing? It largely comes down to two things – investors aren’t aware of the difficulty in making accurate forecasts, and precise quantified forecasts often seem to provide a degree of certainty in an otherwise uncertain world. Psychologists refer to the later as “anchoring” – in times of uncertainty people latch on to almost anything to provide comfort and quantified forecasts do this. I have noticed in investment meetings that broad statements about the direction of the market are treated with far less reverence than hard quantitative predictions.
While I like to think my team are better than the market, I know that if I simply relied on forecasts for key investment market variables (like the share market, bond yields and the exchange rate) to set our investment strategy, it may not be the best way to make money for our clients. So in embarking upon investing what should one do? In my opinion there are several rules worth following.
Rule No 1 – Respect the Market
While it is well known that investment markets are not always rational, there are numerous examples of investors who came a cropper because they thought they were better than the market. In the 1970s, a US investment professional named Charles Ellis likened share market investing to playing a “loser’s game”. A loser’s game is a game where bad play by the loser determines the victor. Amateur tennis or boxing after several rounds are examples of loser’s games, where the trick is not to try to win but to try and avoid making stupid mistakes. As noted in relation to Mr Market, investment markets are fickle, sometimes rational but sometimes far from it and highly seductive and thus are a classic loser’s game in which the winners win by simply not making stupid mistakes.
For many, this means the best approach to investing is simply to adopt and stick to a long-term strategy consistent with one’s objectives. This may mean using managed or indexed funds. For those prepared (or paid like myself) to put the effort in, the next few rules may be of interest.
Rule No 2 – Have a disciplined process
This should rely on a wide range of indicators – such as valuation measures (ie, whether markets are expensive or cheap), indicators that relate to where we are in the economic cycle, measures of liquidity (or some guide to the flow of funds available to invest), technical readings based on historic price patterns for the share market, exchange rate or whatever (the evidence suggests there is value in such analysis) and measures of market sentiment (the crowd is often wrong). The key to having a disciplined process is to stick to it and let it filter all the information that swirls around financial markets so you are not distracted by the day-to-day soap opera that engulfs them. The huge flow of information often confuses rather than aids any decision making. And most of it is just noise anyway.
Forecasting should not be central to this. My preference is to focus on key themes as opposed to precise forecasts, eg, “the US economy is likely to have a soft landing” as opposed to wasting time on trying to ascertain whether growth will be 2.75% next year or 2%.[2]
Rule No 3 – Remain open minded and flexible
Markets regularly prove even the best investors wrong. One should constantly consider contrary views and test them against your own. It is useful to have some form of “stop loss”. In the past I have riden losing positions too long based on arrogant confidence that I will be right (because a forecast says so). A stop loss (either in the form of a formal sell order to reduce/cut a position if the market goes through a particular level contrary to your own position or just a trigger for a review) is useful in forcing investors to consider whether they are on the right track or not.
Rule No 4 – Know your self
Successful investors know their psychological weakness, which are innate to most of us, and seek to manage them. Examples of these include overconfidence, the tendency to overreact to new information, the tendency to look for confirming evidence, and any innate bias towards optimism or pessimism. A key to successful investing is to leave your ego at the door. You can’t expect to be always better than the millions of investors who make up the market. Out of interest I consider myself to be relatively optimistic – and I could argue that history is on my side as share markets rise far more often than they fall. But I recognise it won’t work every year. So I have made sure that I have a range of “less sunny” people around me!
Conclusion
It is always tempting to believe that you or someone else can forecast better than the market. However, nothing is ever that easy. There are plenty of investors who have been “right” on some particular market call but lost a lot of money by executing too early or hanging on to it for too long. The key is to respect the market, have a disciplined process, remain flexible and leave your ego at the door.
By Dr Shane Oliver, head of investment strategy and chief economist, AMP Capital Investors.*
[1] This is a variant on “Those who know, don’t say. Those who say, don’t know.”
[2] Most of my notes don’t use precise forecasts and now you know why. Where I do resort to them, it is only to communicate a view based on a range of other indicators. One area where I believe a kind of forecasting can be useful is in relation to medium term (5-year) views of investment returns. But these are more projections than forecasts as the key driver is current investment yields and they are factual – not a forecast.
