THE FOLLY OF FORECASTING
It may be human nature to want to forecast financial markets in the short-term, but history tells us that attempting to do so may be more than just futile; it could be costly.
IT’S ONLY NATURAL
If there’s one question I get asked the most, it has to be: “What’s your market outlook for the next few months?” It’s a perfectly understandable question—why wouldn’t we want to know the future? But one of the challenges to successful investing is that the road ahead is never clearly known. Thankfully, the markets are not easy to forecast in the short-term, because if they were, they wouldn’t offer the potential for meaningful returns. If it was clear to see that a significant pullback was approaching, and thus easy to profit upon, wouldn’t most investors decide to do this at the same time? Wouldn’t it be obvious, especially to the “smart money” institutional professionals? And if it were obvious, is it worth acting on considering potential tax implications and trading costs?
Take the recent market environment, for example. From the market high in February to the March 23rd low, the market declined roughly 33% (total return, which means inclusive of dividends). Plenty of investors argued as to why the market would continue to decline further as a vaccine was likely years away, businesses were restricted from operating, and unemployment was skyrocketing. Conversely, many investors called for a sharp recovery as they saw the challenges as being serious, but short-term, especially considering the health of the economy going into 2020, imminent government intervention, and so forth. And yet other investors expected a muted recovery full of false starts as society adapts to a new path forward living with COVID. It’s reasonable to believe that all of these scenarios carried at least some merit, and it was certainly plausible that any one of those scenarios might unfold. Which camp were you in? Now fast forward to today and the same market is trading higher and setting new records. Which camp are you in now?
Perhaps you’ve thought to yourself, “The market is totally irrational right now—it doesn’t make any sense.” I’ve had these thoughts myself, but I always have to remember the market doesn’t have to be rational. Could it be, to the contrary, that an irrational market creates opportunity?
PITFALLS AND PUNDITS
I think most would agree that we’re living in a time of information overload. With real-time stock quotes, 24/7 news alerts, and social media platforms all at our fingertips, it’s no surprise that investors often become fixated on what the markets are doing right now and where they could be going next. Compounding the issue is a never-ending stream of “experts” offering their views on the markets as if they have the gift of clairvoyance. And why wouldn’t we heed the free advice from a billionaire hedge fund manager or an exceptionally educated academic sharing their vision of the future? In my view, these experts are—with no disrespect intended—likely broadcasting their views in order to promote a product, fund, book, brand, etc. It’s a low-risk endeavor on their part to offer these…guesses. If they make a correct call, they’ll be on record for being prescient. But if they’re wrong, who will remember? Will anyone hold them accountable? Perhaps I’m too cynical and these experts are really acting altruistically, but I have to wonder, if their forecasts are so sound and profitable, wouldn’t their time be better spent investing according to their convictions rather than sharing them with the masses? Regardless, following short-term forecasts from even the brightest minds in finance can prove ineffective at best and costly at worst.
Let’s suppose a prominent investing guru on TV suggests a certain investment approach. Will that same “expert” be around to tell you when to change course? Will you be tuning in? Or what if they were just wrong? Even the most gifted investors get it wrong sometimes (I won’t name names, but there are countless examples) and not because these experts aren’t intelligent or informed—but because consistently accurate short-term forecasting is virtually impossible. Try this: the next time you see a headline forecasting what you should do with your money, make a note of it. Then set a future calendar reminder to check in and see how it worked.
A BETTER APPROACH
If we agree that we can’t time the market in the short-term, or doing so is futile, should we just give up? Isn’t there a viable alternative? Don’t we need to at least attempt to forecast? I think distinguished investor Howard Marks of Oaktree Capital summed it up best in his July 2007 memo to clients titled It’s All Good when he wrote, “While we can’t know where we’re going, we ought to know where we are.” In other words, having a sense of the current environment is more useful than seeking to forecast the future, because when we understand where are today, we can at least attempt to prepare for various outcomes.
As an example of this in practice, we can observe today that real and nominal interest rates are extremely low. This tells us that fixed-income investments (e.g. bonds) with higher rates of interest likely pose greater risk either by being a longer maturity investment (interest rate risk) or by being a lower quality investment (credit risk) or a combination of both. We don’t know when those risks will manifest in a negative way, but to prepare, we may wish to tilt towards investments of shorter-term and higher quality. From a planning perspective, it also means we should expect lower returns in fixed income investments—rather than assuming strong past returns will continue. Within equity markets, we’re back to pre-pandemic levels, led in large part by technology and growth stocks, but yet we’re in a much less stable economy. The takeaway here is to say that expected future returns should probably be lower than they were six months ago, near the market nadir. Putting this into practice means adjusting your financial plans for potentially lower returns—although we always hope for more.
In my view, the most successful approach—which has been documented time and time again—is to stick with a thoughtfully crafted investment plan that assumes a range of market outcomes. If you think of the markets in the long run, they’ve tended to move higher over time, despite short-term pullbacks (something I consider to be noise). Over these longer periods of time, the investor who decides to eschew the short-term noise and instead stays the course through good and bad, is likely to have more favorable results.
As we head into a major election this fall, investors are again asking what’s in store for the market…and so the cycle continues. The next time someone asks where I see the market going, I’ll share this forecast: expect the market to go up, down, and sideways. That’s a forecast you can build a plan on.
Jeff DeLarme, CFP®
Registered Principal, Financial Advisor
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*Sources: Raymond James and Oaktree Capital (https://www.oaktreecapital.com/docs/default-source/memos/2007-07-16-its-all-good.pd