Prognostications May Be Hazardous to Your (Clients’) Wealth

January 28, 2020

Contributor Matt Potter argues for “a more sound and defensible way to help guide your clients closer to their goals.”

Practically Speaking Blog

This year I will be rooting for the 49ers to win the Super bowl. Not because I like them (in fact I am l lifetime Bears fan), but because of the Super Bowl stock market theory! I am rooting for the 49rs because as the theory goes, when NFC teams win, the stock market does better than the year before – go ahead look it up. I think that it is correct something like 80% of the time! Of course I am just kidding, but when you make year-end adjustments to client portfolios, are you looking at similar meaningless patterns? Do you take the word of a few (or many) trained prognosticators? This week our contributor Matt Potter takes a look at his mailbox and tries to make sense of what people are saying and what they can be doing.

Please enjoy Matt’s Blog --- JDA 

“We know much less than we think even about what is going on, let alone what will happen next.” – James Mackintosh, The Wall Street Journal

Around this time each year, my email inbox starts to fill up with predictions about what will occur over the next 12 months. Some of these authors hold themselves accountable for last year’s predictions and report how accurate or inaccurate they’ve been in the past, but many do not. These forecasts tend to fall into two broad categories: those that are simply pure opinion or guesses, and those that are based (or at least purport to be based) upon some reliable predictive metric.

Last year, I wrote about one of these indicators, the January Barometer. Essentially, in most years when the S&P 500 rose more than 4% in January, the rest of the year showed additional gains for U.S. stocks. Since 1950, this indicator has had a success rate of greater than 90%. Interestingly, the S&P 500 gained more than 4% in both January 2018 and January 2019, presenting two consecutive years to test it. However, those two years experienced completely different outcomes, demonstrating that even a very reliable historical indicator can fail unexpectedly.

Crystal BallSo if an objectively accurate indicator can disappoint, what are the implications for predictions based upon factors such as the Presidential election cycle or the winner of the Super Bowl? Or an investment pundit who makes 10 specific predictions with a great deal of confidence, but doesn’t offer any supportive evidence for why they should manifest in 2020? Or even a well-established predictor, namely, the yield curve, which became inverted last year but then later reassumed a normal upward slope? Clearly, these present much more room for error.

Essentially, I’m asking you to contemplate two questions: 

  1. Which metrics/predictors/information sources do you consider to be valid and useful?
  2. How much weight do you attach to them as part of your process for constructing and adjusting client portfolios? 

I’m assuming you don’t use such data points as astrological indicators or Super Bowl results to guide decisions about your clients’ investments. But where do you draw the line? Are you more bullish than normal because it’s a presidential election year and a columnist you follow said that in the past eight decades, the stock market hasn’t had a down election year when an incumbent was running? Or because you read that 30%+ gains in the S&P 500 are followed by good years more often than not? Or are you more cautious because the five-year vs. three-month segments of the yield curve stayed inverted last year for more than three months?

Perhaps more importantly, if there are indicators or experts in whom you have a lot of faith, what actions are you willing to take based upon what they tell you? For example, are you considering increasing client equity allocations by 10%, or 20% or more? Or conversely, are you leaning towards raising cash to 25% or shifting all equity holdings to lower-beta, dividend-paying stocks? If you’re on the fence about taking some kind of action, what would it take to spur you into making a decision? Would it be one key person pounding the table with a high-conviction call? How about if most or all of the influential firms that you follow adopted a particular stance? Or if a certain number of favored indicators all lined up the same way?

You may be wondering, why did I just ask 16 questions in the three prior paragraphs? (Go ahead and count – I’ll wait.). Here’s why: I’m inviting you to look in the mirror and assess how you make decisions and how your decisions may translate into actions that will impact your clients. Predictions made close to the end of the year somehow seem to carry more weight than those made at other times, but there’s nothing really different about the calendar changing into a new year (except perhaps the tax treatment of income and realized capital gains). However, I suspect that many of us are guilty of ascribing more importance to these kinds of predictions than we should and perhaps even acting on them.

Ultimately, why do you make adjustments to client portfolios? I assume it’s to align their portfolios closer to their goals, or because you believe the changes are in your clients’ best interest. But could it be that you’re trying to gain a slight edge on the market or prove the value you add to your firm’s overall investment process? If your forecasts are right, great – but if you’re wrong, how does that serve your clients? Are they (or you) expecting you to have a forward-looking viewpoint and express it with their dollars? If so, it might be worth re-educating your clients (or you) about how futile it is to predict market behavior.

In an article titled “How to Beat the 2020 Year-End Forecasts," author Joachim Klement, CFA, references a study that examined the accuracy of annual consensus predictions by investment analysts over the past 20 years. He looked only at predictions about the direction the S&P 500 would move (up or down), and found that the analysts were correct only nine years out of 20. In other words, these investment professionals had two simple alternatives for the market–positive or negative–and their success rate was marginally worse than a coin flip. These aren’t stupid people, they’re just attempting something that isn’t possible. And even if they had been correct more often, say 13 or 14 times out of 20, relying on them as an input would have still introduced meaningful risk into any investment process.

I think it’s human nature to want to control the uncontrollable, and predicting the future is one way of attempting to do that. There’s probably little harm in simply forecasting what lies ahead, just as many of us make predictions about who will win the Super Bowl, or an Olympic event or a presidential election. But you risk losing money and credibility if you express such predictions as bets – if they turn sour (which is probably fairly likely), what is the justification for them that you will offer to your clients?

Holding properly diversified portfolios that are consistent with an investor’s tolerance and capacity for risk may seem like a boring alternative, but I would argue that it represents a more sound and defensible way to help guide your clients closer to their goals. Let others make predictions, while you remind your clients that their potential investment success isn’t reliant upon some indicator or guru that may or may not be accurate.

Investing involves risk including possible loss of principal. Diversification may not protect against market risk. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. An inverted yield curve represents a situation in which long-term debt instruments have lower yields than short-term debt instruments of the same credit quality. A normal yield curve slopes upward, reflecting the fact that short-term interest rates are usually lower than long-term rates. 
The S&P 500 Index is an unmanaged, market-weighted index that consists of 500 of the largest publicly-traded U.S. companies and is considered representative of the broad U.S. stock market. Once cannot invest directly in an index.

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