Crystal Balll2

Uselessness of Market Prediction Using Simple Logic

Crystal Balll2

“You make more money selling advice than following it. It’s one of those things we count on in the magazine business—along with the short term memory of our readers.” – Steve Forbes, publisher of Forbes Magazine

It is officially that time of the year again. No we are not talking about the Holidays, but the time when many financial pundits begin making their bold predictions for next year.

“The S&P 500 is going to be strong.”

“Interest rates are going to flatten out.”

“GDP growth is going to slow.”

It’s understandable since it brings excitement to those who are chomping at the bit to get an edge over other investors. As Mr. Forbes suggests in his quote, these are the stories that sell and why pundits do it in the first place.

Imagine a story that read, “we are unsure of how unknown future market events will impact prices”[1] or “we expect capital markets to continue to function properly.” Not really the kind of thing that sparks excitement or action.

But we already know that market predictions are about as useful as a toothache. NOBODY can accurately predict the future with a level of consistency that would render a profitable investment strategy beyond what is expected by random chance. It doesn’t take a tremendous amount of skill to flip 10 consecutive heads in a row, but hey, it happens from time to time.

Here is some simple logic investors can follow that may help them to tune out the financial prognosticators.

Let’s assume that somebody believes that the stock market is going to be negative next year and is looking to cash out. We will give them the benefit of a doubt and assign a 50% probability that they are correct; the same as flipping a fair coin. But we must remember that in order to come out ahead, timing the market involves really two decisions: when to sell and when to eventually get back in. If we assign a 50% probability that an investor get’s each decision right, then they have a 1 in 4 chance (25%) of being better off than just staying in the market. Even if we bump up the probability of success to 70% for each decision, they still have about a 50% chance of coming out ahead. This is still no better than a simple coin flip. What is for certain is that investor will incur transaction costs, potential taxes, and emotional capital on possibly coming out ahead.  

Even the professionals have an extremely difficult time coming out ahead over long time horizons as shown in the table below.

Over the last 10 year ending June 30, 2016, between 85% and 91% of active managers have underperformed their respective benchmarks. Similar results are found for the 1 year and 5 year periods as well. 

What is a more reliable strategy is to just buy, hold, and rebalance a globally diversified portfolio of index funds for the long-term. Markets have rewarded the disciplined investor over time. The chart below shows the Growth of a Dollar invested in the MSCI World Index (net dividends) from 1970-2015 alongside major market predictions by well known financial periodicals.

Once we take the long term view, we can see how ridiculous short term market predictions look in the grand scheme of things.

[1] Dimensional Fund Advisors, LP. “Prediction Season.” December 2016.