The Trouble With Forecasting – Winter 2011

At the risk of sounding like a broken record, allow me once again to admonish and warn you: forecasting the direction of the market is harmful to your financial health. Although I have preached on this topic for decades, we continue to see clients making the mistake of attempting to forecast. The results are generally dismal. If anyone should be able to forecast successfully, it would be those who are paid big bucks to do so: the stock analysts and active mutual fund managers. Yet we have their performance data, and the data shows that on average their stock guesses are no better than the proverbial monkey throwing darts.

Market movement is “event driven”. The day that we can forecast future events is the day we will be able to forecast markets. For example, if you knew for a fact that next Tuesday morning, America would suffer a 9-11 magnitude terrorist attack, then you could make a forecast that the market would drop on Tuesday.

One caveat: if the investing public also knew of the coming event, your knowledge would give you no advantage. Publicly known information is almost immediately reflected in prices. In other words, market prices are forward looking; they take into account future expectations. Therefore, if everyone knew that the terrorist attack was forthcoming, prices would adjust downward to reflect that knowledge before you could act on it. Or for example, if everyone knew that the economy was going to deteriorate over the coming months, there would be no advantage to selling because prices would already be low enough to reflect that expectation.

A forecaster who believes in their forecasting ability is saying one of three things:

1)     “I have material information that the public does not have.”

If this statement is true, it generally involves “insider trading”. Ask Martha Stewart how that went for her.

2)     “ I get material information before the public does.”

This statement is unlikely to be true, and even if true, it is unlikely to be of advantage. As new information evolves from rumor to fact, it does so incrementally. At any given point in time the probability that it is accurate is quickly reflected in real-time prices. The small incremental advantage that accrues by obtaining knowledge a few seconds or minutes before other investors is obtained through trading, and the high costs of trading generally offset any advantage.

3)     “I analyze public information better than other analysts do”

This third statement reflects arrogance, or at least an overestimation of one’s abilities. There are literally thousands of highly educated and experienced analysts pouring over stock reports, market data, and economic statistics daily. They have the resources to compile reams of information quickly and the experience to analyze the import of it. An investor who studies the economy and the markets a few hours per day is just playing around by comparison.

We often hear an analyst, advisor, or investor say “the market is high”, or, “the market is low”. Since no one knows whether the future market will rise or fall, it cannot be said that the market is “high” or “low” compared to the future, and in terms of investing, the future is all that matters. What is really being said is that the market is “high” or “low” relative to the past. Unfortunately, the past price direction is not related to the future price direction. For example, if the market rises, it is just as likely to continue to rise as a market that has recently dropped. A market that drops is just as likely to continue to drop as a market that has just risen. In other words, past price movement is worthless information.

Market forecasting is damaging. Those who forecast a down market and sell their equities earn low cash returns, foregoing the opportunity for higher average market returns over the period of time they are in cash. In the same way that a gambler makes money from time to time, a market forecaster calls it right at times, but over very long periods of time, both the gambler and the market forecaster are victims of mathematical reality.

Disclosures: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

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