“It’s not the bear you see. It’s the one that jumps you from behind you have to worry about.” – Classic hunting wisdom
At any point in time, there is a general mood and a popular forecast about what will happen. The popular media and most investors generally have the same future expectations.
The surprising truth, however, is that these popular forecasts rarely happen.
Believing popular forecasts can have significant consequences. It leads investors to make the wrong guesses in their investment decision-making process which can be seen in the “Behavioral Gap” – consistently buying high and selling low.
“The majority is always wrong.” 1
Most experienced investors that have been around the markets for a decade or more have learned to take popular forecasts with a lot of skepticism. Instead, they focus on the valuation of the underlying investments to guide their investment decisions. The wisdom that investors need to learn is that: “The majority is always wrong.” 1
Even less accurate are popular forecasts of major financial catastrophes. The major financial catastrophes that actually happened in recent years were not widely predicted. It’s not the bear you see that you have to worry about.
Here are the most popular forecasts on New Year’s Day in recent years:
Popular Forecasts in Recent Years
|Year||Most Popular Forecast on New Year’s Day||Did it happen?|
|1999||Y2K millennium bug will crash many computers.||No|
|2000||DOW 36,000 – 25% per year growth will continue. Buy Nortel||No|
|2001||We had a small correction. NASDAQ & DOW will soon be back to their highs||No|
|2002||Recovery will start in spring. The market recovered after 9/11. Recession is shallow.||No|
|2003||Fear. Avoid stocks. SARS will have a major economic effect.||No|
|2004||2003 was a “dead cat bounce”. A “double dip recession” is likely.||No|
|2005||US real estate boom will continue.||No|
|2006||Income trusts will continue to soar. Which company will convert to an income trust next?||No|
|2007||Continuing of “Goldilocks economy”. US real estate downturn won’t affect the economy.||No|
|2008||We are running out of oil. Oil will reach $250 per barrel. Canadian dollar will reach $1.20.||No|
|2009||Panic. The financial system will collapse. DOW will fall to 5,000.||No|
|2010||We are in the “Great Recession”. A “double dip recession” is likely. H1N1 virus.||No|
|2011||Europe will collapse because of the PIIGS (Portugal, Italy, Ireland, Greece & Spain)||No|
|2012||Europe will collapse. Austerity and “age of deleveraging” will lead to years of low growth.||??|
Notice how consistently the popular forecasts are wrong?
The surprising part and what I personally find most staggering, is not that they rarely happen, but that most investors always believe the latest one will happen this time. If the last 14 popular forecasts were wrong, why does everyone believe the latest one?
There are many reasons these popular forecasts are so consistently wrong. The main reasons are:
1. Assuming trends will continue
Most popular forecasts merely extrapolate current trends into the future. They are really true of last year, not of next year. Human brains naturally assume trends will continue, even though nearly everything in the financial world goes through cycles.
For example, there were a lot more people forecasting a market crash in the years after the 2008 crash than before the crash happened.
2. Assuming nobody will do anything about issues
Forecasts of financial collapses always assume that nobody will do anything. Everyone with authority to deal with the issues will just stand around and watch.
For example, the current forecasts of a financial collapse in Europe assume nobody will be able to prevent it. Solutions to the issues in Europe, such as Eurobonds and a common bank guarantor are well known, but the politicians are taking a long time to negotiate them. However, if necessary they will do whatever it takes to maintain stability. Why would everyone assume politicians and financial authorities will stand around while Europe collapses around them?
3. Not realizing that markets already “price in” known information
Mass opinions are already “priced in” to investments. Today’s prices for investments are based on all the known information and expectations about what investments are worth.
For example, when everyone expects a market crash because of Factor X, then the prices of stocks already assume that Factor X will happen. Most investors fail to realize that if Factor X does actually happen, it will likely have little effect because markets had already priced it in. Any effect of Factor X on the markets already happened.
4. Valuation matters
Popular forecasts focus on trends and events, and generally ignore how cheap or expensive various investments are. Never forget – eventually valuation matters.
For example, during the tech boom around 2000, the technology industry made amazing claims, such as that in about 10 years internet traffic would be millions of times higher and that there would be more handheld devices on the internet than computers. Most of these claims have come true, but the technology-heavy NASDAQ index is still valued at half of what it was then. This is because the prices of technology stocks in 2000 included all the expected growth (and more) and were hugely over-valued.
Today’s Popular Forecast
Today’s popular forecast goes something like this: The stock market will go nowhere for the next 5 or 10 years because we are in an “age of deleveraging”. Austerity (government spending cuts) around the world will keep growth very slow and unemployment high. Europe will continue to struggle and the European Union may collapse. Greece may leave the European Union, and Spain and Italy are next. So you should stick with investments that “pay you to wait” by paying interest or a dividend or some kind of yield.
Sound familiar? This view is all over the financial news and blogs.
Will it happen? The simple fact that forecast is popular makes it doubtful.
There are many possible outcomes. The popular forecast is by no means inevitable.
I recently attended a talk by Niels Veldhuis, the president of the Fraser Institute. His main thesis was that when Canada went through deleveraging and austerity, it led to higher growth. In the mid-90s, Canada had run up a huge debt and there was speculation as to when we would hit the “debt wall”. Then we cut back spending and paid down the debt. Greater confidence in our finances and less government promoted growth. In Canada, it did not lead to years of low growth.
What can we learn from this?
1. The simple fact that a forecast is popular makes it doubtful.
I just returned from 3 conferences. At one, there was a panel of 5 good investment managers and about 2,500 financial planners in the audience. One of the investment managers said that he did not expect interest rates would go up in the next couple of years. After a general murmur of disapproval went through the audience, he said: “Do you want to know why I think that? How many of you here think that interest rates will go up in the next couple of years?” Virtually every hand went up. He said: “There is a forest of hands up. That is why I don’t think that will happen.” 2
2. Never forget – eventually valuation matters.
Popular forecasts are far more useful as a measure of current market sentiment than as actual predictions. They tell us which sectors of the market may be overvalued or undervalued due to the current sentiment.
For example, investors everywhere are “chasing yield” today. That makes most yield investments, such as bonds and dividend paying stocks, priced higher than normal. Even if news is favourable for them, their future returns are likely to be lower because they are not cheap today.
At the same time, today’s popular forecast is that there will be little growth in the next few years, so growth investments, such as stocks and equity mutual funds, are relatively cheap.
The best investments are usually in undervalued sectors – not the popular sectors. Because of their valuation, the best investments are rarely the ones you would expect based on the popular forecast.
3. Don’t follow the herd.
The cost of investing based on popular forecasts, in most cases, is reduced investment returns because you are not investing when markets are undervalued. Despite the fact that it is logical to buy low and sell high, many studies show that most investors consistently do the opposite. This “Behaviour Gap” wipes out about 2/3 of long term investment growth of the average investor. 3
Key investment wisdom to remember:
- It’s not the bear you see that you need to fear.
- The majority is always wrong. 1
- The simple fact that a forecast is popular makes it doubtful.
- Market trends usually reverse. Markets go through cycles.
- Never forget – eventually valuation matters.
- Don’t follow the herd.
1 “In economics, the majority is always wrong.” John Kenneth Galbraith
2 Just because a forecast does not happen, it does not mean that the opposite will happen. There are many possible outcomes. The fund manager in the story is not expecting interest rates to go down. He is expecting they will take more than a few years before they go up.
3 “2012 QAIB – Quantative Analysis of Investor Behavior”, Dalbar, Inc.
About the Author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching. If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com. You can read his other articles here.