Prophets & Losses: Predicting the Market is a Losing Proposition

Right now there is a lot of noise in the system. The din of the pundits quickly becomes deafening as they try to tell you what the markets are going to do this year. The financial media does this every year, and even more so with this year’s volatile start.

This type of prognostication sells, but it’s entertainment, not solid financial advice. Their goal is to stir the pot in order to get people to pick up a magazine, watch a commercial, or click a link. In good times, they will appeal to your greed rather than your fear to make you feel like you’re missing out.

In other words, forecasting is a moneymaker, so they keep putting out these prediction pieces. Unfortunately, people actually believe these predictions, and then invest based on them. The latest headline from CNNMoney: “Sell Everything! 2016 will be a ‘cataclysmic year,’ warns RBS.” How is someone supposed to react to this in a rational manner?

People buy into these articles for a very human reason: The financial markets are confusing, and we just aren’t wired to accept uncertainty. We desperately want to understand what is going on.

These types of articles purport to provide that understanding. They claim to give inside knowledge of what will happen next – we just need to do whatever the article tells us. The author always backs up their claims with logic and sound reasoning. The whole argument ties together perfectly, so why wouldn’t it work?

The problem is this: If it makes sense to you, it makes sense to a whole bunch of other people, and they got there first, so the markets have already adjusted prices accordingly. The fact that analysts think 2016 will be a bad year means traders think regular investors will decide to sell stocks, so they want to get out ahead, which drives prices down. The market simply reacts to new information faster than pretty much anyone can trade on it.

As baseball legend Casey Stengel said, “Never make predictions, especially about the future.”

While we don’t know what the market is going to do in the future, we know exactly what the market did in the past, and we know what predictions were made last year. So let’s check to see how good those predictions actually were.

Before we take a look at the numbers (and I wrote this before I looked at the numbers), let’s think about what we should expect to see. If we think these predictions are basically random (which I do), then we should expect about half of them to be right and half to be wrong, depending on how specific the predictions are. It’s worth noting that they aren’t paying investment expenses on these predictions – if they had to pay those expenses (like you would to act on these suggestions), we would expect more than half of these predictions to be wrong.

Looking at the Data

Theory is great, but what matters are actual results, so let’s look at the data. Compiling a list of every pick from every financial publication online and in print is pretty much impossible, so I’ve compiled a reasonably representative list. I compiled 54 total picks from five of the biggest names in the financial media.

The S&P 500 Index returned 1.38% in 2015[ii].

Overall, the predictions did pretty much exactly what we expected. A little bit less than half of the stocks picked went up over 2015 (all of the picks that were positive also beat the S&P 500 Index), and the average return of all of the picks was pretty close to the return of the S&P 500 Index (1.38%). In fact, if they were trying to match the market returns, it’s pretty much impossible to do better.

The point is this: trying to guess what the market is going to do is like trying to predict the weather an entire year in advance – sometimes you will get lucky (Barrons), and sometimes you’ll miss the mark (Money Magazine). Claiming to have any sort of authority on what the stock market or Mother Nature will do this year is plain silly.

Mid-Year Results

You see the same story if you split the year in half. During the first half of the year, these picks actually looked pretty good. 57% of the picks made money through June 30, and the average return was beating the S&P 500 Index – 4.96% to 1.23%. But everything fell apart after that. From the beginning of July until the end of the year, only 35% of the picks had positive returns, and they lost to the S&P 500 Index – 3.24% to 0.15%.

In fact, the two best performers over the first half of the year got pretty well clobbered during the second half. The best performer from January to June was Credit Acceptance Corporation. It was up 80.47% during the first half, but it dropped 13.06% the rest of the year. Diplomat Pharmacy, the second best performer of the picks from January to June, was up 63.50%, but the second half found it down 23.53%.

It’s easy to pick out examples like this because short term returns are basically random. How a stock or market acts one day or month doesn’t tell us much about what it will do in the future.

Short Term Randomness

The randomness of short-term stock returns can be seen in the daily movements of an index versus its long-term performance. Let’s look at the Dow Jones Industrial Average last year (last year I wrote a whole article on the problems with the Dow, but it works for our purposes here). You probably hear what the Dow did every day on your drive home from work, so hopefully this will put some of those numbers in perspective.

Last year, the Dow Jones Industrial Average was down 398.04 points, or -2.23%[iii]. Not a good year, but moderately flat – not much motion when you look it from a distance. But what if we zoom in and look at the daily movements? The sum of the absolute value of each day’s movement for the year was 31,839.34 points.

This is roughly the equivalent of driving roundtrip from DC to San Diego – twice – just to get to Philadelphia[iv]. And all of these daily movements are what you hear on the radio every day coming home from work.

Think about that: the average daily movement of the Dow was 126.85 points. On an average day last year, the Dow moved a little less than 1/3 of its total annual return (126.85/398.04 = 0.32). The fact that the Dow was only down about 400 points for the year simply means there were a couple more bad days than good days last year.

Speaking of individual days, you can’t predict how big a day’s move will be. Consider August 24 and August 26, 2015. The former was the market’s worst day of the year, while the latter was its best. In two days, the market moved more than 1,200 points.

Active Management Doesn’t Work

Everyone wants an easy answer with the stock market. Everyone wants to know what to do next. But no matter how much economists, financial professionals, and the media prophesy, they know just as much as the rest of us about what’s going to happen. Outguessing the market is impossible.

Financial markets react too fast to new information to successfully try to guess what the market will do next. By the time you read the latest predictions, prices have already reacted to them and are already reacting to the next thing. Unless you happen to live in the show Early Edition, it just won’t work.

Just look at the performance of stock pickers and active managers. As we saw above, it’s pretty much a coin flip. Over the course of last year, 47% of the picks we looked at had positive returns and 53% were negative. And that’s without thinking about expenses. Once you start taking out fees, it switches from a zero sum game to a negative sum game.

Active management just adds volatility to the mix. The stock market, as we saw from the Dow’s daily returns, is already a roller coaster. You don’t want to take on any more volatility – especially when you don’t get an increase in expected return out of it.

The Effects of Volatility

Extra volatility is dangerous. It’s all well and good to talk about everything being random so it will all average out in the end. Leaving aside the question of fees, active management should average out to the market return. The problem is that you live off of total returns, not averages. Let’s put some numbers around this.

Say you own a share of Acme, Inc. You bought it last year at $50. This year has been a tough one and it’s dropped 50%, so now it’s worth $25. To get back to $50, it doesn’t just need to go up 50% next year, it actually needs to go up 100%. If Acme were to go up 50%, it would only be worth $37.50, not the $50 you bought it at.

Making up for lost ground is harder than losing the ground, and adding random noise to your portfolio just makes it harder to reach your objectives. While you might have a good year and beat the market, like the Barron’s picks did, you are just as likely to do worse than the market, like Money Magazine did. The cost of losing to the market is worse than the benefit of beating the market.

What about Macro Predictions?

We just reviewed individual stock picks. Can the experts get general market forecasts correct? To address this we will refer to a great piece written by Robert Seawright where he reviews how accurate Wall Street’s top economists were in predicting the stock market in 2015.

So what were these “entertainers” up to in 2015? Sadly, it was same ol’, same ol’. As ever (see here, here, here, here, here and here for just a few past examples), their predictions and forecasts were simply dreadful. It’s almost getting boring to point out the obvious – we humans simply don’t generally make forecasts very well.

In general, Wall Street’s top strategists expected the S&P 500 to rally 10 percent in 2015.* Instead, it ended 2015 at essentially the same level it started. It opened the year at 2,058.9 and closed the year at 2,043.9, a loss of less than one percent (nominally; with dividends factored in, the S&P 500 gained a bit over one percent). Note the following strategist forecasts for the S&P 500 and by how far – yet again – they missed the mark in the aggregate.

• Goldman Sachs’ David Kostin: 2,100
• Barclays’ Jonathan Gilonna: 2,100
• Credit Suisse’s Andrew Garthwaite: 2,100
• Deutsche Bank’s David Bianco: 2,150
• BTIG’s Dan Greenhaus: 2,200
• Citi’s Tobias Levkovich: 2,200
• Bank of America Merrill Lynch’s Savita Subramanian: 2,200
• Nuveen’s Bob Doll: 2,200
• UBS’ Julian Emmanuel: 2,225
• BMO’s Brian Belski: 2,250
• Morgan Stanley’s Adam Parker: 2,275
• Oppenheimer’s John Stoltzfus: 2,311
• RBC’s Jonathan Golub: 2,325
• FundStrat’s Tom Lee: 2,325
• Blackstone’s Byron Wien: 2,368

One can see similar failures in bond market predictions and commodities such as oil. While they are making educated guesses, they are still just guesses based on factors that have hundreds of interdependencies outside anyone’s control.

Focus on What You Can Control

Don’t look for investing shortcuts. Shooting for a high score with your investments doesn’t work. The aim of disciplined investors is to meet your goals while taking the least risk possible.

You want to build your portfolio around the things you know will help you reach your goals. You want to build a well-diversified portfolio that takes the types of risk the market pays you for, and harvest market returns. Above all, you need to stay disciplined.

Sticking to your plan is paramount. If you know where you want to go, and how to get there, you don’t need to worry about all of the different ways you can go. You want to stick to the path you have already plotted. You will need to make changes along the way, but they should be based on what is going on in your life, not what you hear the markets might do.

Plus, don’t we already have enough people loudly predicting disasters and claiming to know what to do next in the primary races?

The most important thing you can do for your finances is make sure you have a solid financial plan in place. Without a plan, you can’t know if you are on track to meet your goals.

To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors.

Appendix

All returns data for picks was calculated from Yahoo Finance’s adjusted close value. The adjusted close value adjusts for stock splits and dividends paid. Stocks that merged with another company or were bought by another company were excluded from the analysis. Three stocks were excluded: Merge Healthcare (Forbes), Hospira (Money Magazine), and RTI International Metals (Money Magazine).

“10 Favorite Stocks for 2015” Barrons

“15 Great Stocks for 2015” Forbes

*Merge Healthcare was purchased by IBM. It was excluded from the analysis

“12 Great Stocks for 2015” Money Magazine

*Hospira was bought by Phizer. RTI International Metals was bought by Alcoa. Both securities were excluded from the analysis.

“7 Stocks to Buy for 2015” CNN Money

“James K. Glassman’s 10 Stock Picks for 2015” Kiplinger’s

[i] Picks that were bought or merged with another company were excluded from both the % of Picks Positive and the Average Returns. See the pick list for details.

[ii] S&P 500 Index data courtesy of Dimensional Fund Advisors.

[iii] All Dow Jones Industrial Average data provided by Samuel H. Williamson, ‘Daily Closing Value of the Dow Jones Average, 1885 to Present,’ MeasuringWorth, 2016.

[iv] Driving distances from Google Maps. Driving distance from our office in Tysons Corner, VA to San Diego CA is 2,680 miles, and the driving distance from our office in Tysons Corner, VA to Philadelphia, PA is 150 miles.