Every January Wall Street’s strategists offer careful, nuanced and even compelling outlooks for what will happen in the markets and in our world in the coming year. But whenever I look back at how those various predictions turned out, I have found that they are like August humidity in the South — consistently and astonishingly dismal. Moreover, when one of them does get a forecast right or almost right, that performance quality is not repeated in subsequent years.
My friend Morgan Housel, a columnist for Motley Fool, looked at the average Standard & Poor’s 500 stock index forecast made by the 22 chief market strategists of the biggest banks and brokerage firms from 2000 to 2014. On average, these annual forecasts missed the actual market performance by an incredible 14.6 percentage points per year (not 14.6%, but 14.6 percentage points!).
Alleged experts miss on their forecasts a lot and miss by a lot, a lot. Let’s stipulate that these alleged experts are highly educated, vastly experienced, and examine the vagaries of the markets pretty much all day, every day. But it remains a virtual certainty that they will be wrong often, and often spectacularly wrong. On account of hindsight bias, we tend to see past events as having been predictable and perhaps inevitable. Accordingly, we think we can extrapolate from them into the future. But the sad fact is that we can’t buy past results. We cannot predict the future.
The market predictions offered by experts (and others) and the thought processes underlying them can be very entertaining. They are indeed the engine that drives much of what pretends to be financial and business television. But none of us should take them seriously. Your crystal ball does not work any better than anyone else’s.
Sadly, such dreadful forecasting performance is indicative of dreadful investment performance. The vast majority of investment strategies are predicated upon the ability to forecast the future. These results are no better than the forecasts. As longtime chair of the Yale Endowment Charles Ellis outlines it, research on the performance of institutional portfolios shows that after risk adjustment, 24% of funds fall significantly short of their chosen market benchmark and have negative alpha, and 75% of funds roughly match the market and have zero alpha, while well under 1% achieve superior results after costs — a number that is not statistically significantly different from zero, largely because of fees.
To pick one particularly egregious example, hedge funds — despite (and partly because of) enormous fees — have badly underperformed. Since 1998, the effective return to hedge fund clients has barely been 2% per year, half the return they could have achieved simply by investing in Treasury bills.
Thus, per Nassim Taleb, successful managers have risen “to the top for no reasons other than mere luck, with subsequent rationalizations, analyses, explanations, and attributions.” In other words, we desperately pull money from our latest poorly performing strategy to put it into some new approach that has been doing great, only to see the same pattern repeat itself.
Sound familiar? John Paulson achieved great notoriety for betting against the real estate markets ahead of the 2008–09 financial crisis and accumulated billions of investor dollars into his hedge fund as a result, only to get crushed in 2014, losing 36% in his Advantage Plus fund despite a very strong market environment.
Not only is it really hard to beat the market overall, but when you do make a smart investing move (purchasing an investment that will actually outperform, however you define that), its impact is reduced every time somebody else follows suit. It is axiomatic in the investment world that as an asset class becomes more popular, it suffers from both falling expected returns and rising correlations. Crowding occurs because success begets copycats as investors chase returns. General mean reversion only tends to make matters worse.
In other words, the more smartness there is in the aggregate, the less you can profit from it. Michael Mauboussin describes it as the paradox of skill: “As skill improves, performance becomes more consistent, and therefore luck becomes more important.” Accordingly, those (very) few funds and managers that have a successful long-term track record end up outperforming their peers by precious little indeed.
On the other hand, the impact of bad decision-making stands alone. It isn’t lessened by the related stupidity of others. In fact, the more people act stupidly together, the greater the aggregate risk and the greater the potential for loss, which grows exponentially. Think of everyone piling on during the tech or real estate bubbles. When nearly all of us make the same kinds of mistakes together — when the error quotient is really high — the danger becomes enormous.
Perhaps worst of all, the returns achieved by investors are even lower than those obtained by managers because we are enslaved by our emotions and poor decision-making. When something isn’t right (or doesn’t seem right), our default response is to do something. And what we do is to insist on buying what was just hot and selling what has just underperformed, guaranteeing that we buy high and sell low, which is exactly what we shouldn’t do.
We all want “high leverage” ideas — the ideas that will make the biggest impact on our portfolios and our lives. But the best ideas available are not still more investment recommendations about hot sectors, hot funds, hot strategies and hot managers. There is no reason to think anybody can do that anyway.
The best ideas I can offer relate to our besetting mistakes, mistakes we make over and over again. My high leverage idea for 2016 and beyond is to get off the merry-go-round of the next new thing and to eliminate obvious mistakes first and foremost. As Charley Ellis famously established, investing is a loser’s game much of the time, with outcomes dominated by luck rather than skill and high transaction costs. Thus if we avoid mistakes we will generally win.
To paraphrase the philosopher Immanuel Kant, the first task of reason is to recognize its limitations. Every rational person acknowledges having made many errors. Even so, nobody offers current examples. We all want to think that our mistakes are in the past, that we’ve learned from them and that now we’ve set things right.
We desperately want to believe that our new approach, new strategy or new portfolio will — finally — be the magic elixir that will make us very good, if not great, investors (or at least that we can find those great investors).
Since we can’t forecast the future, it is imperative that our investment approaches resist the temptation to build our investment platforms on future forecasts. Accordingly, here is a quick summary of my top investment ideas for 2016 (or any other year), none of which is dependent upon prophecy.
Einstein wisely advised that we keep things as simple as possible, but no simpler. Overly complicated systems, from financial derivatives to tax systems, are difficult to comprehend, easy to exploit and possibly dangerous. Simple rules, in contrast, can make us smart and create a safer world.
Out of our general fear, we all too frequently bail on our investments and our plans and fail to invest altogether. But if we’re going to succeed, we need to invest, continue to invest and stay the course. Multiple studies have shown that those who trade the most earn the lowest returns. Remember Pascal’s wisdom: “All man’s miseries derive from not being able to sit in a quiet room alone.”
The Uniform Prudent Investor Act stated: “Because broad diversification is fundamental to the concept of risk management, it is incorporated into the definition of prudent investing.” Fortunately, a well-diversified portfolio captures most of the potential upside available with much lower volatility. On the other hand, a well-diversified portfolio will always include some poor performers, and that’s hard for us to abide. Do it anyway.
The idea that an investor ought to be aware and nimble enough to avoid market downturns or simply to find and move into better investments is remarkably appealing. But nobody does it successfully over time. We’ve all seen and done this: we find a hot new approach or hot new manager and, because what we own hasn’t been doing so well, we switch, only to find that the hotness that caused us to buy has cooled. We need to get off that merry-go-round.
The leading factor in the success or failure of any investment is fees. In fact, the relationship between fees and performance is an inverse one. Every investor needs to count costs.
Multiple studies establish what we should already know: a manager who has a significant ownership stake in his fund is much more likely to do well than one who doesn’t. Make sure to look for “skin in the game” from every money manager you use.
Don’t be afraid to ask for and get help. American virologist David Baltimore, who won the Nobel Prize for Medicine in 1975, once told me that over the years (and especially while he was president of Caltech) he had received many manuscripts claiming to have solved some great scientific problem or overthrown the existing scientific paradigm to provide some grand theory of everything. Many prominent scientists have drawers full of similar submissions, usually from people working alone and outside the scientific community. As Dr. Baltimore emphasized, good science is a collaborative, community effort; crackpots work alone.
A smart investor looks for what can be done that offers the greatest opportunity to achieve success in the markets. Finding and implementing these best ideas is deceptively easy conceptually yet monumentally hard to put into practice. Let’s start by systematically eliminating our most obvious mistakes. The more we do that, the better 2016 can turn out to be, irrespective of what the markets do — no predictions required.