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.