A Fool's Game

It’s prediction time! But that doesn't mean that anyone should make them. Or, if made, which is the mode de January, anyone should pay any attention to them. Why? Because no one is any good at it and by a big margin of evidence.

Then why is it such a common rite of the New Year for pundits and writers of all stripes to launch off into what ends up amounting to fantasy? Because life is defined by uncertainty and we will go to sometimes extraordinary lengths to reduce that quantity from our lives. And money matters are pretty high on everyone's list of things that they do not want to be uncertain about. So we get financial predictions, for better or, usually, worse.

As evidence of our collective fecklessness, Phillip Tetlock of the University of California, Berkeley wrote a book about his studies on the subject: Expert Political Judgement; How Good Is it? How Can We Know? In a seven-year study across an array of fields, including economic ones, even the most recognized forecasters could not rise to a level of 20% correct.

What is not surprising is that statistical models were better forecasters with even crude ones getting things right 25% to 30% of the time. The most sophisticated ones stretched as far as 47%. But still not even money. If you need more sharp-edged proof, consider that "From 1992 through 2011...the S&P posted annualized gains of 5.8% while individual investors earned just 3.5% annually."

Why is that, you might reasonably ask. In a word, the answer is "emotion." Algorithms don't have them and we do. In recognition of that fact, it is estimated that the 2,000 or so PhDs working on Wall Street have constructed automated programs that now account for an amazing 70% of all trading activity.

I have written about some of our foibles before, but it might be instructive to review some of them now that January, the month of New Beginnings, has rolled around again. Such as the fact that individual investors are 50% more likely to sell a winning stock than to sell a loser — even though winners tend to continue performing well while losers are often in a downward spiral. This from another Berkeley professor, Terrance Odean.

He points out that selling an underwater asset "...isn't primarily about economic loss, it's about emotional loss...so you can no longer tell yourself 'I made a good choice and it'll come back.'" Unfortunately, this same tendency also applies to mutual fund managers who are also human. And that is why virtually all of them fail to consistently outperform the market.

It seems that we all hope, for better or worse — with rationalizing data or without — that our losing holdings will recover. That is only one reason why we should all put up a big sign on the wall in our offices that reminds us that "Hope is not a strategy!"

That is why, at the least, we need a second, professional opinion. Or a change in approach; consider selling losers as a swap, even for a similar, but more promising asset. And remember that you can use up to $3,000 in losses to offset gains on your taxes. Cold comfort maybe, but we've got to take what we can get.

Or we can follow John Bogle's advice. He is the founder of the Vanguard family of funds and has been telling anyone who will listen for years that they will always do better just "buying the market." Preferably through an Exchange Traded Fund (ETF), which simply owns every stock in an index or sector. ETFs don’t buy or sell, except in the event of a merger or a delisting, so overhead is miniscule.

In the case of Schwab's version, for example, the cost is just $4 per $10,000 of holdings. Bogle points out that trading and overhead costs of even 1% per year over a saving and investing career may cost you up to one-third of your possible net holdings. You will hit no home runs by buying ETFs, but you will be protected from your own expensive mistakes, insuring your future a bit more and, possibly as a fun bonus, outperforming most of your more venturesome friends.

So in the New Year, when you see financially related ads that proclaim, often in small print, that "Past results do not guarantee future returns," believe them. Really believe them. Predicting, and the implied acceptance of that prediction, is a fool's game.