A basic tenet of active stock market investing is that certain experts can help predict what will happen to the market. They do this using sophisticated tools and (maybe) years of education. The idea is that these stock markets experts will then use the predictions correctly to earn you greater return on your investments compared to the market average.
Tantamount to the success of this plan is the actual ability of these experts to make accurate economic and market forecasts and predictions to use. Even more over, the returns generated by these forecasts and predictions need to overcome higher fees and taxes compared to a passive index investing strategy.
So, should we just take Wall Street’s word on it that their predictions hold muster? I say no.
Let’s take a look at some of the data.
Can experts predict the economy or stock market?
You’ll notice here that I am intertwining the overall economy and the stock market. In general, the gasoline for the stock market is the economy. So predicting one accurately generally predisposes to an accurate forecast of the other.
Plus a lot of the data we have looks at both of these factors.
Much of this data comes from William Sherden who is an author and professor at Stanford Business School. I first came across his work in The Quest for Alpha by Larry Swedroe.
A good start
Sherden first got into the analysis of forecasting as an expert witness in a court case in 1985. Basically he analyzed the track records of people/systems predicting inflation by different methods. He compared the “expert” predictions against “naive” predictions – basically a random guess.
And guess what?!
The naive predictions outperformed the expert ones based on data from big-time firms and PhDs!
The big one
After this, Sherden analyzed the leading research on forecasting accuracy from 1979 to 1995 and forecasts made from 1970 to 1995.
First and foremost, I recognize that this data is old. But it is still some of the best that we have. And more over, a forecast in the past should be as good as a forecast in the future. Sure, technology changes. But that should not significantly impact our forecasting in the economy and market (more on this below).
With this in mind, let’s take a look at some of the big findings from this particular study:
- Of 48 predictions made by economists, 46 were wrong. That’s a whopping 0.042 batting average. If these predictions were a baseball player, they’d be sent back to Little League ASAP.
- When the “experts of the experts” were examined, including the Federal Reserve and Congressional Budget Office, their forecasting records were worse than pure luck would dictate.
- No particular forecasting or economic strategy produced consistently better predictions.
- Even more, no one expert consistently produced more accurate predictions.
- Forecasts made via consensus committee of multiple experts did not better than individuals.
- Psychological bias plays a role as some experts were consistently optimistic while others were consistently pessimistic.
- And lastly, increased sophistication in the prediction models did not improve accuracy.
Some conclusions
No matter the credentials, no one is accurate when it comes to forecasting the economy or, by extension, the stock market. In fact, having credentials may actually make your predictions worse!
This is Wall Street’s dirty little secret. And it’s persisted because of some expert marketing on Wall Street’s part. But it’s also persisted because, as humans, we are so conditioned to accept that more experience should lead to better results.
As doctors, we believe this even more about ourselves and about the world in general.
But this is the exception. Unfortunately, things get even worse.
When the chips are down, stock market and economic forecasters do worse
A quick question for you to think about: When would you want predictions to be more accurate – when the stock market and economy are up or when they are down?
If you are like most of us, accurate forecasts during market downturns are more important. Both because, as humans, we feel losses more than we feel wins, and because a 1% error in accuracy for a growth market doesn’t make as much of a tangible difference as such an error when the market is down.
So, do forecasters do better or worse when the economy is down?
Worse…they do worse.
Sherden found this is his big study. Forecast accuracy was worse at the turning points of the economy.
This finding was further confirmed in a 2009 study by economist Michael W. McCracken. He reviewed 26 years of quarterly forecasts made by members of the Survey of Professional Forecasters from 1981 to 2007.
Ultimately, he found that forecasting errors were four times (four times!) less accurate during a recession compared to when it was not.
Ouch.
In the words of the man himself…
Sherden observes the following:
“Despite recent innovations in information technology and decades of academic research, successful stock market prediction has remained an elusive goal. Overall, we have not made progress in predicting the stock market.”
He goes on to advise the investor as such:
“Avoid market timers, for they promise something they cannot deliver. Stop asking yourself and everyone you know, ‘What’s the market going to do?’ It is an irrelevant question, because it cannot be answered.”
And just to beat a dead market horse…
The media does even worse than experts. This seems like common sense. But yet millions of viewers still tune into the MSNBC and other finance/business programs hoping to learn some nugget that will provide them with superior market returns.
Philip Tetlock, a professor at Berkeley, Worte a book sharing findings of his 20-year study in which experts were asked to predict the future.
I will spare you all of the findings, however, Tetlock finds that all experts, but especially public ones in the press or doing consulting, do no better than a chimp throwing darts. They are just louder and more widely broadcast.
What’s the moral of the story?
Trying to achieve superior market returns through active investing in prevailing economic conditions requires accurate forecasting.
Unfortunately, economic and stock market forecasts are uniformly not accurate more than chance would suggest, even when made by “experts.”
This pulls the rug right out from under the whole concept of active investing. And that’s even before we talk about the fees and taxes.
So, what is an investor to do?
- Create a savings rate of at least 20%
- Build a basic goal asset allocation of stocks and bonds
- Re-balance back to your goal asset allocation yearly
- Invest passively to capture market returns via index funds
- And then, if you ever get bored of index funds, ignore the noise and do any of these 7 things instead of straying from your plan!
What do you think? How have your predictions about the stock market gone? Have you ever found someone who is consistently accurate? If so, please tell us in the comments below!
