Even a crystal ball won’t help

Posted by TEBI on October 30, 2020

Even a crystal ball won’t help

 

There can’t be many investors who haven’t wondered at some point, “If only I had a crystal ball!”

Think about it. Imagine you had correctly predicted the outcome of the Brexit referendum or Donald Trump’s election victory in 2016. Imagine, back in January 2020, when reports were circulating of a virus breaking out in China, having a sudden realisation that the world was about to be gripped by a pandemic which would bring the global economy almost to a halt.

But even if you had known about all of those things in advance, would it have helped you to beat the stock market? In the latest in his series Investor Tales, LARRY SWEDROE explains why, in the context of investing, having a crystal ball is overrated.

 

 

It must be apparent to intelligent investors that if anyone possessed the ability to do so [forecast the immediate trend of stock prices] consistently and accurately he would become a billionaire so quickly he would not find it necessary to sell his stock market guesses to the general public.

—Weekly Staff Letter, August 27, 1951, David L. Babson & Company, quoted in Charles Ellis, The Investor’s Anthology

 

It was Thanksgiving Day 2003, but Tina was not in a festive mood. The papers finalising her divorce had come in the mail the day before. Her 30-year marriage to Tim was over.

While Tina was not worried about her financial situation (the court having awarded her a $5 million settlement), she was feeling particularly vulnerable. She realised she knew almost nothing about managing financial assets. Tim was the one interested in the market. She had left all of the investment decisions to him, but now that responsibility was hers. She’d heard lots of stories about people being exploited by unscrupulous, commission-based investment advisers. She had to find someone she could trust.

Tina decided to call Bob, the attorney who’d handled her divorce. She was hoping Bob could recommend a trustworthy adviser.   

 

Bob: Tina, I know you must be concerned about finding someone you can trust. Several of my clients, all women in similar situations, have been working with a local CPA who is also a registered investment advisor. I’ve known Katie for 20 years and can certainly vouch for her character. She does my taxes and manages my investments. I’d be glad to call her for you and have her contact you.

Tina: That would be great. I really like the idea of having an accountant also serve as my financial adviser. A one-stop approach appeals to me. I would also appreciate it if you could give me the names of a few of the women who work with Katie. I prefer getting referrals from an independent source. I’m sure Katie wouldn’t give me referrals who would say negative things.

Bob: I’d be happy to do that. I’ll call them to see if they’re willing to speak with you.

Tina: That sounds great. I really appreciate your help.

 

What Wall Street doesn’t want you to know

The next day Katie called Tina to introduce herself and set up an appointment. She told Tina she was sending her the book What Wall Street Doesn’t Want You to Know.

Reading the book was her homework assignment in preparation for the meeting. Katie explained that the book would provide her with a basic understanding of the firm’s investment philosophy and advice on how to choose an investment adviser. It included a list of questions Tina should ask of any advisor she planned to interview. Tina thanked Katie and agreed to read the book before their meeting.

Bob called later that day with the names of three women who had hired Katie as their accountant and financial adviser. They all told Tina they were extremely pleased with Katie. They told her Katie worked hard to educate them about investing. She made sure they not only participated in the decision-making process but, after carefully explaining the pros and cons of various alternatives, left the final decisions to them. She would then play devil’s advocate to make sure they fully understood the risks before implementing anything. Tina liked what she heard and was looking forward to the meeting.      

Over the course of the next two weeks, Tina read the book and took copious notes. She knew that choosing an investment adviser would be one of the most important decisions she would make. She wanted to do everything she could to ensure she made the right decision. She knew that the wrong decision could not only prove costly but would be one from which she might not recover. With help from the book, she came to the meeting prepared with a long list of due diligence questions.

As far as Tina was concerned, the meeting could not have gone better. Katie not only did a great job explaining the firm’s philosophy and how she worked with clients but also listened carefully to her concerns and satisfactorily answered her questions. She told Katie she would like to work with her.

 

Implementing the plan

Over the course of the next few weeks, Tina and Katie held several meetings. Right after the new year, they met to finalise and implement the plan. Katie explained that based on her assets of $5 million, Tina could prudently plan to withdraw living expenses of $150,000 per year, which was 3 percent of the current value of her assets. The amount would then be adjusted each year to take inflation into account. That was good news, as it was more than sufficient to allow Tina to maintain her current lifestyle.

By the end of the meeting, Tina was confident that together they had developed an overall financial plan that addressed all of her financial needs, including such issues as long-term health care and other types of insurance. Her investment plan was also integrated into an overall estate and tax plan. There was only one issue that was making her somewhat nervous.

 

Tina: Katie, I’ve been comfortable with the entire process, and I have confidence in you. Having said that, I’m nervous about investing $5 million dollars at one time when all I’m hearing on radio and television and reading in the papers is that now is a risky time to be in the market. The news is filled with the problems of a jobless recovery, outsourcing of jobs, huge budget and trade deficits, and how the sharp rise in the price of oil is hurting the economy. Then there are the problems in the Middle East and the escalating problems of terrorism as it spreads around the globe. And aren’t interest rates set to rise sharply? Is now really a good time to invest?

Katie: I’m glad you asked that question. First, it’s important to acknowledge that there are always risks when investing. Second, as I told you at our first meeting, everything we do is based on academic evidence, not on my opinions. So let me tell you about the evidence on the ability of people to forecast the economy.

William Sherden is the author of a wonderful book, The Fortune Sellers. If you’re interested in reading it, I’m happy to lend you our copy.

Sherden was inspired by personal experience to write his book. In 1985, when preparing testimony as an expert witness, he analysed the track records of inflation projections by different forecasting methods. He then compared those forecasts to what is called the “naïve” 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 PhDs from leading universities and thousand-equation computer models.

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

• Economists can’t predict the turning points in the economy. Of the 48 predictions made by economists, 46 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. 

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 the economists.

 

The example of 2003

Let me give you a concrete example of why you should treat all prognostications about the stock market as nothing more than what I call “investment graffiti”. It will demonstrate that even if you have a clear crystal ball and are thus able to foresee events (though not stock prices) that will occur in the future with perfect clarity, you should still avoid trying to time the market. As you consider this example, keep in mind that Sherden’s study demonstrated that no one in the real world has that perfectly clear crystal ball.

Let’s review what happened to the equity markets in 2003. To begin, it was the best year for equity investors in the last quarter-century. Not since 1975-76, when global markets were recovering from the bear market of 1973-74, did investors earn such high returns. U.S. large-cap stocks rose in excess of 25 percent. U.S. large value and real estate investment trusts rose in excess of 30 percent. International large value stocks rose in excess of 40 percent. U.S. small-cap, international small-cap and emerging market stocks all rose in excess of 50 percent. U.S. micro-cap stocks and international small value stocks rose in excess of 60 percent. And emerging market value stocks rose in excess of 70 percent.

It’s important to point out, however, that almost no one, if anyone, forecasted a bull market in 2003, let alone the kind of returns that were actually experienced. And if any investor had a clear crystal ball allowing him or her to foresee the events that would occur in 2003, they almost surely would have forecasted a bear, not a bull, market. I know I would have.

Let’s review some of the major events that occurred that year. Not only would we go to war in Iraq without U.N. support, but the markets would also have to deal with the ongoing uncertainty that existed even after we declared military victory. The markets would also have to deal with an outbreak of SARS, corporate scandals, mutual fund scandals, record trade and budget deficits, a renegade North Korea, an escalation of the Palestinian-Israeli conflict, the threat of deflation and a jobless recovery.

Even if you had a clear crystal ball to foresee the news events that would impact the market, it would have done you little good. In fact, in all likelihood it would have hurt you. You would almost surely have missed one of the great bull markets of all time.

Thus, the conclusion I draw, and I hope you will agree, is that you should ignore — or at least treat only as entertainment (because their crystal balls certainly are not clear) — the market forecasts of Wall Street strategists. Perhaps my example will help you appreciate the old joke that there are only three types of market forecasters: those that don’t know where the market is going, those that don’t know they don’t know where the market is going, and those that know they don’t know but get paid a lot of money to pretend that they do.

We’ve developed a well-thought-out plan, and we should not allow, now or ever, the noise of the market to distract us from that plan.

 

Invest everything at once?

Tina: Thanks for the explanation, but I’m still nervous about investing the entire $5 million all at once. Do I have to do that?

Katie: No, you don’t. I’ll explain the alternatives and, as I always do, provide you with the academic evidence on which is most likely the best choice. Let’s begin with the fixed-income portion of your assets. If you recall our conversation, based on the academic evidence and your need for cash flow, we’re going to invest that portion of your portfolio in very high quality and relatively short- to intermediate-term instruments. Those types of investments entail little risk.

Thus, I see no reason to leave money on the table, which is what we’d be doing if we kept those assets in a money market account until you feel better about the investment environment. Since you have little need to take risk, the fixed-income assets account for 60 percent of the portfolio, or $3 million, so I suggest we invest that immediately.

Tina: That sounds fine.

Katie: Great. I’ll place the order to invest those funds right after we conclude the meeting. Now let’s address the $2 million of equities you plan to invest. From an academic perspective, the answer is simple. Since the market rises a majority of the time, and there is no evidence of the ability to time markets, the way to put the odds in your favor, which is the best we can do, is to invest it all now. If you do otherwise, the likely result is that you will eventually buy at higher prices.

Unfortunately, people don’t always base investment decisions on logic. In fact, when it comes to investing, my experience is that the stomach often plays a greater role in decision-making than the mind. One of the most important roles I play is to make sure that, as much as possible, you are allowing your mind to make decisions, not your stomach.

It’s also my experience that almost all investors, faced with the same situation you’re confronting, are sure that if they were to take the plunge and invest all at once, that day would turn out to be a peak the market wouldn’t exceed until the next millennium. That causes them to delay the decision altogether, with often paralysing results. If the market rises after they delayed because they felt prices were too high, how can they buy now at even higher prices? And if the market falls because the bear market they feared has arrived, how can they buy now? The problem is this: Once a decision has been made to not buy, exactly how do you make the decision to buy?

I believe there’s a good solution to this dilemma, one that addresses both logic and emotion. I recommend that if you can’t get yourself to invest all at once, let’s write down a plan that you’ll agree to adhere to. The plan will lay out a schedule with regularly planned investments. There are three alternatives I suggest you consider:

• Invest one-third of the investment immediately, and invest the remainder one-third at a time over the next two months or next two quarters.

• Invest one-quarter today, and invest the remainder spread equally over the next three months or quarters.

• Invest one-sixth each month for six months or every other month.

I’ve suggested a maximum of one year because the longer the schedule, the more likely it is you’ll miss out on market gains. What do you think?

Tina: I understand the logic of the take-the-plunge approach, but I just feel more comfortable going a bit slower. I’ll sleep better that way. I like the idea of investing one-quarter now and the remainder spread equally over the next three quarters.

Katie: I’m going to have this written up and ask you to sign a document authorising me to make those investments as you have instructed. I want you to know that I’m going to implement the plan regardless of how the market performs. Are you okay with that?

Tina: Yes, I understand.

 

A glass-half-full perspective

Katie: Great. I have another suggestion regarding this plan. I suggest you now adopt a “glass-half-full” perspective. If the market rises after we make the initial investment, you’re going to feel good about how your portfolio performed. You’re going to congratulate yourself for not have delayed investing. If, on the other hand, the market falls, you’re going to feel good about the opportunity you now have to buy more at lower prices. You’ll also congratulate yourself for being smart or lucky enough not to have put all of your money in at one time. Either way, you’re going to win, at least from a psychological perspective. Can you do that?

Tina: I think so. And more importantly, I understand the message.

Katie: I have just one more question for you. Tomorrow we’re going to invest one-fourth of your $2 million. After tomorrow, are you going to root for the stock market to go up or down?

Tina: Why, up of course!

Katie: No, Tina, you should actually root for it to go down. The reason is that we’re going to be buying more in the future, and I’m sure you’ll agree that it’s better to buy at lower prices rather than higher. If the market falls, that’s exactly what we’ll be able to do.

Tina: I see, but I’m not sure I can root for the market to go down.

Katie: I really don’t expect you to, but you can see that it will actually help us in the long term. With this knowledge, perhaps you’ll feel better about a bear market if that’s what happens. Do you have any more questions?

Tina: No, I’m ready.

 

Staying on track

Katie: I want you to feel free to call me with any type of question. I’m not on any clock in terms of the fees you pay. I’ll be calling you shortly after the end of the quarter to set up a meeting. You’ll receive an agenda to review ahead of time. If you want to add anything, just let me know. You’ll also receive a quarterly portfolio analysis report for review prior to the meeting. I may even make some comments on it for you to consider.

At each meeting I’m going to ask if anything has changed in your life that would cause us to revisit the assumptions we used in developing the plan. I’ll also ask you how you’re feeling about the markets and how your portfolio is doing. That will help me address any issues you might be concerned about. We’ll also review the performance of the portfolio to see if we’re on track to meet your long-term goals or if any adjustments need to be made.

We’ll also check to see if the market has moved in such a way as to cause our asset allocations to drift away from the desired percentages. If that’s the case, we’ll decide if any rebalancing is needed and how best to accomplish it. And we’ll also check for any opportunities to take a loss for tax purposes, as harvesting losses reduces your overall tax bill. Then we’ll discuss whatever other issues you feel are important. How does that sound?

Tina: This has been great. I really feel comfortable now.

Katie: Thanks. I appreciate your trust and confidence.

 

The moral of the tale

Casey Stengel, generally considered one of the greatest baseball managers, was known to have said: “Forecasting is very difficult, especially if it involves the future.”

Even if you had a crystal ball that allowed you to foretell future events, timing the market might still be a loser’s game.

The winning strategy is to adhere to a well-thought-out plan and ignore the noise of the market.

 

LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
Want to read more of Larry’s insights? Here are his most recent articles published on TEBI:

A higher intelligence

Unique insight or common knowledge?

What investors can learn from Moneyball

When even the best are unlikely to win

Sport, investing and the paradox of skill

The names are never the same

 

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