January 8, 2014

Prediction Season

Following the end of year holiday season is a somewhat less celebrated but equally anticipated season.  No, I don’t mean award season.  I’m talking about prediction season.  Prediction season is when many Wall Street pundits and talking heads, otherwise known as Chief Market Strategists and Chief Investment Officers, earn their keep by predicting the return on the stock market for the New Year. 

I personally find the prediction season much less enjoyable than the holiday season.  The reason being is not so much that stock market predictions are consistently off the mark (I find that part rather comical) but rather because of the harm done to investors who are led to believe they need market predictions to be successful investors.  Too often, investors and their advisors regard predictions as quasi reality and use them to position their investment portfolios.

To begin with, let’s review how awful Wall Street strategists are at predicting stock market returns.  According to a recent Wall Street Journal article, Birinyi Associate’s (a well-known stock market research firm) average of eleven Wall Street strategists’ predictions for the 2013 return on the S&P 500 index was a gain of 8.2%.  The actual return was 32.39%, a difference of slightly more than 24%.  Isn’t it mind-boggling that supposed expert predictions could be off by over 24% for a period of just one year?   I suppose it’s even more amazing that they are being paid to make these predictions.

Beyond the issue of market predictions being a pointless waste of time, there is a more serious issue to consider.  Many investors are lulled into believing they need predictions to position their portfolios.  Imagine it’s December 2012 and Joe Investor gets a call from his broker that the firm’s resident market guru (Chief Market Strategist) is calling for an 8% return on the S&P 500 for 2013.  Joe and his broker discuss his portfolio in the context of this prediction and decide that if the market is only going to return 8% for the year, especially in light of a dysfunctional Congress, tepid economic growth, Middle East conflicts and Global Warming, that it might make sense not to bother with stock market volatility for a while, at least until the world calms down a bit.  So Joe and his broker agree to move his balanced 60% equity/ 40% fixed income portfolio to all fixed income for the year. 

Assuming a flat return on the fixed income assets (a generous assumption as most high quality fixed income asset classes had negative returns in 2013) and an equity allocation returning an amount equal to the S&P 500 index, the repositioned portfolio would have underperformed the original portfolio by over 19%1.   Thanks for nothing Mr. Market Strategist….

A better approach to portfolio management eschews predictions and instead focuses on each investor’s desire for equity risk.  We begin the process by accepting that we (meaning myself and everyone else involved in investing) don’t have a clue what the market return is going to be over the near term.  Next, we generate a downside risk estimate for Joe’s portfolio by asking, how would this portfolio have performed in a 2008-type scenario in which global equities fell by roughly 50%2?    

Presented with a downside risk estimate on his portfolio of 30% (50% equity downside risk x 60% equity allocation), Joe can respond in one of three ways:  Too risky, not risky enough or just right.  All of these responses can be addressed by reviewing the long-term asset allocation of the portfolio such that it matches his desire for equity risk.  In any case, without the input of a market prediction, Joe’s portfolio will generate a return commensurate with his desired equity risk exposure. 

So much for prediction season…

1 The numbers would look worse if transaction costs and taxable events generated by portfolio repositioning were included.

2 Global equities (as measured by the MSCI World Index) fell 48.59% between October 2007 and March 2009.