Of Blind Squirrels and Flying Pigs: The Fallacy of Market Predictions

A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting. —Warren Buffett

The dollar is collapsing and global investors are dumping dollars so it will continue to fall. That in turn will lead to higher inflation and then the Fed will have to raise interest rates. Oil is closing in on $100 a barrel. We have the worst housing market since the Great Depression. There is a financial crisis caused by the subprime mortgage debacle. Banks are tightening credit standards. And if you needed more reasons to believe the stock market was headed south you could always throw in global warming.

Given all of these obvious reasons to be bearish about stocks, what should investors do? The answer is nothing, except to adhere to their well-thought-out plans. There are many reasons for ignoring even what seems to be obviously bearish information. Let’s see why this is the case.

Confusing Information with Wisdom

The first reason investors should ignore such forecasts (no matter how rational the arguments sound) is that the information on which such forecasts are based is certainly known by the market—it is not insider information. Thus, the market has already incorporated the information into current prices. In other words, it is already too late to act. Prices should fall further only if future information about the market turns out to be worse than was already expected. In other words, it does not matter if news is good or bad. Markets only move when information is better or worse than was expected. And if something is unexpected, by definition it is not predictable. Being unaware of how the market sets prices is one of the worst and most common errors investors make. They fail to account for the fact that the market already takes into account all that they know.

The Collective Wisdom of the Market

The collective wisdom of the market in setting prices is a very tough competitor indeed. Consider the following. William Sherden is the author of a wonderful book The Fortune Sellers. In 1985, when preparing testimony as an expert witness, he analyzed the track records of inflation projections by different forecasting methods. He then compared those forecasts to what is called the “naive” forecast—simply projecting today’s inflation rate into the future. He was surprised to learn that the simple naive forecast proved to be the most accurate, beating the forecasts of the most prestigious economic forecasting firms equipped with their Ph.D.s from leading universities and thousand-equation computer models.

Sherden then reviewed the leading research on forecasting accuracy from 1979 to 1995 and covering forecasts made from 1970 to 1995. He concluded that:

• Economists cannot predict the turning points in the economy. Of the forty-eight predictions made by economists, forty-six missed the turning points.
• Economists’ forecasting skill is about as good as guessing. For example, even the economists who directly or indirectly run the economy—the Federal Reserve, the Council of Economic Advisors and the Congressional Budget—had forecasting records that were worse than pure chance.
• There are no economic forecasters who consistently lead the pack in forecasting accuracy.
• There are no economic ideologies whose adherents produce consistently superior economic forecasts.
• Increased sophistication provides no improvement in economic forecasting accuracy.
• Consensus forecasts offer little improvement.
• Forecasts may be affected by psychological bias. Some economists are perpetually optimistic and others perpetually pessimistic.(1)
  

Since the underlying basis of most stock market forecasts is an economic forecast, the evidence suggests that stock market strategists who predict bull and bear markets will have no greater success than do the economists.

Market Timing Strategies: The Evidence

The evidence from studies on market timing strategies demonstrates how unlikely it is that one can outperform by trying to exploit pricing errors the market makes (e.g., ignoring such obvious bad news). Consider the evidence from a study on Tactical Asset Allocation (TAA), a market timing strategy. For the twelve years ending 1997, while the S & P 500 on a total return basis rose 734 percent the average return for 186 TAA funds was a mere 384 percent, about half the return of the S & P 500 Index.(²⁾

Another study of 100 large pension funds and their experience with market timing found that while they all had engaged in at least some market timing, not one had improved its rate of return as a result. In fact 89 of the 100 lost as a result of their efforts, and their losses averaged an incredible 4.5 percent over the five-year period.(3)

Perhaps it was evidence like this that led legendary investor Warren Buffett to conclude: “We continue to make more money when snoring than when active.”(⁴⁾ Another legendary investor Peter Lynch concluded: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”(⁵⁾ And John Bogle, Vanguard’s legendary founder, had this to say on the matter: “The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible. After nearly fifty years in this business, I do not know of anybody who has done it [market timing] successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.(⁶⁾

Fooled by Randomness and Hindsight Bias

For the period from 1926 through 2006, the S & P 500 Index produced negative returns 23 of the 81 years. If someone forecasted a bear market every year they would have been right almost 30 percent of the time. In other words, even blind squirrels occasionally find acorns. However, the media is quick to anoint those blind squirrels as gurus. Of course, when future forecasts turn out wrong, rarely are the gurus held accountable because accountability would ruin the game—you would no longer need to “tune in.” So a new guru is anointed. And the game goes on.

Investors are often fooled by predictions that were nothing more than random outcomes. Those that forecast that U.S. stock market will fall much further than it has already in the Fall of 2007, might be right. In fact, there is a significant chance they will be right (probably about 30 percent). Obviously, if you get make enough forecasts you will eventually get some right. And if you (or some guru) make a forecast that turns out to be right, the reaction that most people have is that the forecast resulted from skill rather than luck. And thus too much confidence is placed on the next forecast. And we have seen the evidence on market timing strategies.

Another problem that investors have is that as humans we tend to be biased in that we remember the correct forecasts and forget the bad ones. This type of hindsight bias makes us susceptible to believing that events are more predictable than they actually are. And that promotes overconfidence. Financial columnist and author Jason Zweig offered this bit of advice: “Whenever some analyst seems to know what he’s talking about, remember that pigs will fly before he’ll ever release a full list of his past forecasts, including the bloopers.”(⁷⁾

Summary

The ancient Scythians discouraged frivolous prophecies by burning to death any soothsayer whose predictions did not come true. (This had the desired outcome of reducing the number of such forecasts.) Today’s investors would be better off if market forecasters were held to such biblical standards.(⁸⁾

Doing nothing in the face of such obviously bad news (and falling stock prices) is difficult for most investors. That is why one of the most important roles of a financial advisor is to make sure their clients act like postage stamps. Postage stamps do only one thing, though they do it exceedingly well. They adhere to their letter until it reaches its destination. Investors need to adhere to their investment plan (asset allocation), ignoring the noise of the market and emotions such as fear and panic, until they achieve their financial goals. By doing so, they, like Warren Buffett, will continue to make more money when snoring than when active.

And finally, Meir Statman, behavioral finance professor at the University of Santa Clara, California, provides the following advice: “Start keeping a diary. Write down every time you are convinced that the market is going to go up or down. After a few years, you will realize that your insights are worth nothing. Once you realize that, it becomes much easier to float on that ocean we call the market.”(⁹⁾

1. William Sherden, Fortune Sellers

2. David Dreman, Contrarian Investment Strategies, p.57.

3. Charles Ellis, Investment Policy (Irwin Professional Pub 2nd edition 1992).

4. 1997 Berkshire Hathaway Shareholder Letter.

5. Worth (September 1995).

6. John Bogle, Common Sense on Mutual Funds, p. 20.

7. Money, (November 2000).

8. Jason Zweig, Your Money or Your Brain, p. 76 (Simon and Schuster 2007).

9. Quoted in Wall Street Journal, August 6, 1998.

_{Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn’t Want You to Know (2000), Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003), and co-author of The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006). He is also a Principal and Director of both Research of Buckingham Asset Management and BAM Advisor Services — a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices — in Clayton, Missouri (www.bamservices.com).}

_{His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.}

Comments

[T Muller]

Great Article. I especially agree with the market discounting mechanism of known information and collective sentiment.

Everyday I read/hear an investor recommending to stay away from financials. Why? (Basically everyonbe gives the same reason)

-Because we just don't know how bad it really is and everyday we wait for the next shoe to drop and when it happens we still know there are more to follow. We know financials are facing a crisis, but until there's visibility I would stay away. The unknown is just too great.

Do they mean wait for visibility so then we can buy shares AFTER they have gone up 30% or what have you.

The whole market knows 'they don't know" that's why financial shares have gotten a beat-down- to a reduced price to compensate for the risk (which is defined by uncertainty).

And when the next shoe drops, will shares fall? Investors expect more writedowns so I think let the shoes drop, shares will probably rise since those events at least should start bringing in more clarity.

Some financial stocks should trade at these levels or even lower, and there are some that are very oversold. Still wouldn't touch countrywide though.

Thanks for sharing your insight.