Pitfalls of relying on financial forecasts

By Alan Clarke

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Quite often people decide someone is great because they predicted the global credit crunch or some other big event.

But the real question is what else did he/she predict? All of us can make predictions and all of us will be right occasionally.

But where is the person who can consistently make correct predictions? Certainly I have not met him or her, and I'm guessing you haven't either. Furthermore I doubt that you and I ever will.

Eugene Ionesco once said, "You can only predict things after they have happened."

Supposedly, some of the smartest people in the world work in financial markets, so why are their predictions and forecasts so unreliable? A recent survey compared the experts and their active investment funds to the relevant indexes:

  • International share funds - 77.98 per cent underperformed.

  • Real estate funds - 70.24 per cent underperformed.

  • Emerging market funds - 82.89 per cent underperformed.

  • Government bond funds - 75.66 per cent underperformed.

Share brokers and fund managers alike

A forecast for, say, an individual stock usually depends on a multitude of other assumptions. If just one of those assumptions proves incorrect, the whole edifice comes crashing down.

In June 2009, a brokerage house raised its price target on Research in Motion (RIM), maker of the Blackberry mobile device. Rating the stock as a "conviction buy", they raised their six-month price forecast to $C96 from $C85.

But by May 2012, RIM shares were trading at a little under $C12.

What they didn't foresee was the phenomenal uptake of the Apple iPhone and devices running Google's Android operating system. For whatever reason, consumers decided the Blackberry phone was clunky and uninteresting in comparison.

Alongside incorrect assumptions, changes in technology and shifting consumer preferences, forecasts often can fall down because of external events totally unrelated to the company under consideration.

"What causes governments to run off course ? Events, dear boy, events." - Harold Macmillan.

Stock-picking is much the same. Correct forecasting requires an ability to predict news before it happens (how silly is that?) It doesn't matter how smart an analyst might be, things can still happen out of left field that can wreck their careful analysis.

This is why we should diversify widely - across stocks, asset classes, industries and countries. We need to lessen the impact of the unexpected.

We like to think we can

Some of us believe we can make the right forecasts, predictions and/or pick stocks, but Dalbar research in the US reveals that most DIY investors make 4 per cent less than they could have if they just spread their money across the market.

Why, then, are there so many?

Many of us prefer instead to seek the experts who can, and there are plenty of them telling us that indeed they can.

Commissions and brokerage

They make plenty of money, too. The recent Mighty River Power share issue paid various organisations a total of $9.5 million in commissions just to sell the Mighty River share float to retail investors.

But all too often the investor just gets a mediocre outcome.

What can the investor do?

Find the most efficient funds you can, and diversify widely across them.

Make sure you take advice and/or buy from someone who does not take brokerage or commission, so you are sure that no conflicts of interest exist.

We prefer to diversify over bonds, property and shares, on and offshore, using efficient non-forecasting funds. Over the past 12 months we have had returns of 36 per cent gross from global hedged share funds, 32 per cent gross from the NZX50 share fund, and around 10 per cent after fees and most taxes from our balanced funds.

We did not predict any of these returns; rather we built widely diversified asset class portfolios, based on the science of investing, and incorporating the work of Professor Eugene Fama. He has won many awards including the inaugural Deutsche Bank Prize in Financial Economics in 2005, the inaugural Morgan Stanley American Finance Association Award for Excellence in Finance in 2007, and the inaugural Onassis prize for services to global finance in 2008. He does not forecast or stock-pick, either.

This article was supplied by Alan Clarke, author of Retire Richer - A Practical Guide For Everyone Aged 25 to 85. Clarke also blogs on www.investandretire.co.nz and is an authorised financial adviser whose disclosure statement is available on request and free of charge.

- Hamilton News

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