The Power of Forecasting
As an investor, which broadsheet, investment bank or asset manager should one listen to? All have their vested interests which often can be quite disguised.
As I entered the holiday season I was looking forward to the annual deluge of market forecasts that were to come across my desk from the many self proclaimed experts and commentators. I find myself sitting here during the New Year lull imagining that I was a client with the weekend papers in front of me. As expected I have stumbled across an article titled ‘FTSE forecasts year-end 2010’. The forecasts range from 3,980 to 6,000. The FTSE is currently trading at 5,412.88. Most of the rationales behind the various predictions are feasible and some may actually transpire. Behind the predictions lie valid economic arguments, but which one will prevail?
I also looked back at The Economist’s predictions in 2007 for 2008 and in 2008 for 2009. They missed the global financial crisis in 2008 but Philip Coggan (their capital markets editor) correctly predicted that 2009 would bring more stability and a return towards relative normality. As an investor, which broadsheet, investment bank or asset manager should one listen to? All have their vested interests which often can be quite disguised. How exciting would a broadsheet be if it didn’t provide you with insight, analysis and predictions? It is part of the human psyche to look forward.
If it is understood that most financial commentators are trying to make things sound exciting so viewers/ readers are entertained and are not held accountable or are compensated for the accuracy of their comments or predictions, perhaps it is better to look elsewhere for insight into the future. Perhaps it is worth looking at what the professionals who are compensated and accountable for their comments and predictions are saying, namely endowments, pension funds and other institutional investors. By sheer chance, I happened upon an interesting article over the holidays that wouldn’t appear in the bestsellers lists. It appeared in the latest addition of the Financial Analysts Journal and was titled: ‘Absence of Value: An analysis of Investment Allocation Decisions by Institutional Plan Sponsors’. Prior to reading the article, one would have thought that the experts making allocation decisions for the largest institutions would be at the top of their field for a reason – the ability to add value.
The conclusion of the article was that the typical institutional portfolio is suffering due to an undisciplined and backwards looking investment strategy. In general, investments that institutions sold outperformed new investments that replaced the old ones. The problem is so widespread and common that the authors estimate the cost of this strategy was over $170 billion over rolling five year periods. This is prior to the transaction costs of re-balancing which the authors estimate may double the cost of these poor decisions.
My newspaper with financial predictions is heading for the log fire with the last remnants of the wrapping paper, but I would like to draw your attention to an excellent paper published in the Quarterly Journal of Economics (1970) – The Market for Lemons. The basic premise behind this paper is that goods or services (in our case investment ‘alpha’ is the ‘lemon’) are sold with a label of quality and it is difficult for the purchaser to assess the quality. Investment products are generally sold under the assumption that historical performance (alpha) can be repeated. As I have read in the papers this holiday season, it seems even the experts have a difficult time achieving this let alone mere mortals.
It is all a matter of perception.
Economic Forecasting in an Uncertain World
“As an economist and policymaker, I have plenty of experience in trying to foretell the future, because policy decisions inevitably involve projections of how alternative policy choices will influence the future course of the economy. The Federal Reserve, therefore, devotes substantial resources to economic forecasting. Likewise, individual investors and businesses have strong financial incentives to try to anticipate how the economy will evolve. With so much at stake, you will not be surprised to know that, over the years, many very smart people have applied the most sophisticated statistical and modeling tools available to try to better divine the economic future. But the results, unfortunately, have more often than not been underwhelming. Like weather forecasters, economic forecasters must deal with a system that is extraordinarily complex, that is subject to random shocks, and about which our data and understanding will always be imperfect. In some ways, predicting the economy is even more difficult than forecasting the weather, because the economy is not made up of molecules whose behavior is subject to the laws of physics, but rather of human beings who are themselves thinking about the future and whose behavior may be influenced by the forecasts that they or others make. To be sure, historical relationships and regularities can help economists, as well as weather forecasters, gain some insight into the future, but these must be used with considerable caution and healthy skepticism.”
Ben S. Bernanke Address at the 2009 Commencement of the Boston College School of Law, Newton, Massachusetts, May 22, 2009.
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