• INSIDE THIS ISSUE
• 
• Opening Article
• 2011: A Year in the Balance
• 
• Economics
• A Major Macro Experiment
• 
• Equities
• The Hangover Part II
• 
• Commodities
• Almost
• 
• Currencies
• Standing Still?
• 
• Special Article
• The Folly of Predictions
• 
• MASECO Update
• 
• Indicators
• 
• Contact & Disclaimer

Special Article: The Folly of Predictions

It’s that time again when harried finance editors ask reporters to call investment professionals and cobble together top predictions for the coming year. These are fun to write. But for readers, they’re more entertaining a year later.

Take the late 2010 Barclays Capital Global Macro Survey of more than two thousand institutional investors. The pick for the best performing asset class in 2011 was equities (with 40% support), followed by commodities (34%) and bonds (less than 10%) (1). The consensus prediction was a 15% gain in the S&P 500 for the year to around 1,420.

As we now know, reality turned out to be rather different as Bonds performed the best, followed by commodities and finally equities (see our Indicators page at the end of this publication). Barron’s, meanwhile, was telling readers this time last year that smart stock pickers were “looking eastward” in 2011. The year was to be dominated by fast growth and rising inflation, and the smart thing was to over-weight China and the other ‘Tigers’(2).

That didn’t turn out to be such a good recommendation, as China’s equity market had another bad year and lost value (the Hong Kong Hang Seng index was down by more than 22% in 2011 and the Shanghai Composite was down by a similar amount).

Conversely, the gloom around fixed income in late 2010 was all-pervasive. Barron’s surveyed ten strategists and investment managers and found nearly all expected stocks to outperform bonds in 2011. “You’ve got to believe in outright deflation to put new money into bonds right now,” said one analyst(3).

The logic might have been impeccable, but the strategy wasn’t so. As of early December, US debt securities, as measured by a Bank of America Merrill Lynch index, had risen by 8.7% in 2011, their best performance since 2008(4).

In other words, bond yields might have been seen as unusually low a year ago. But they have fallen even further since, and those who tried to profit by market timing or making concentrated bets elsewhere have paid a heavy price.

So if the experts can’t predict the direction of the broad asset class movements correctly and consistently why do they keep trying?

Stock picks often go wrong because forecasters base their calls on what turn out to be incorrect assumptions on macro-economic variables like base lending rates and inflation.

Take the AFR Smart Investor magazine “expert panel”, which in late 2010 suggested to readers moving out of international fixed income and into cash given expectations of rising cash rates in Australia(5). As it turned out, Aussie rates did not move until November, and when they did the direction was down, not up.

Currencies are another variable that defy even the most assiduous forecasters. In its 2011 outlook, published in the Daily Telegraph in December 2010, a major UK bank forecast that sterling would be the best performing currency of the year appreciating to 1.82 against the dollar(6) – it barely moved (year over year) and closed 2011 at 1.5550 and never climbed above 1.6725.

The banks also predicted stock markets would outperform bonds, with the FTSE 100 rising about 18%. A year later the FTSE was nearly 6% lower.

It’s a tough business, isn’t it? And remember these are major financial institutions with armies of expert analysts, mountains of data, spending billions of dollars and sophisticated forecasting tools. So what is an ordinary investor supposed to do?

Lessons to be learned

The first lesson might be that forecasting is hard, particularly in the short term! You can do all the analysis you want, but unexpected events have a way of humbling us. Who would have thought that after the US lost its AAA status the dollar would rally and there would be flight to US Treasuries?

The second lesson is you don’t really need forecasts to succeed as an investor. Yes, equity markets were rocky again this past year, but a properly diversified fixed income portfolio provided stable returns to counterbalance the negative return in most equity markets.

Staying diversified both across and within asset classes helps lessen the effects in down times and ensures you are still positioned to reap returns when riskier assets come back into demand. Taking a global approach enables you to benefit from higher interest rates in certain markets but comes with it the additional uncertainly of volatile currencies in the short term.

The third lesson is that the past has gone. The best performing equity market last year was the US and the strongest currency the dollar. The news may be gloomy, but that information is in the price. When risk appetites are low, the price of safety is higher than at other times. But the expected reward for owning risk assets (such as equities) is higher. Conversely, when risk appetites are high, the expected reward on risk assets is lower.

It’s human to feel anxious about bad news because we fear loss twice as much as we appreciate gains(7). But this emotional reaction hurts us and it makes sense to remain disciplined and to allocate capital to asset classes that are cheap and remove capital from asset classes that are expensive via a rigorous rebalancing process. This conventional wisdom flies in the face of our natural instincts.

The final lesson is that nothing lasts forever. In fact, of all the forecasts ever made, the only one really worth counting on is that “things change”. What’s more, they often change in ways we least expect.