You're Smart, But You Can't Forecast
As one of those folks who has spent a lot of time bashing economic and stock-market forecasters (see this, this, and this), I have no choice but to take issue with an argument made by former hedge-fund manager Jesse Felder, who asserts "that everything is a forecast." To quote Felder:
Can we please stop bashing forecasters already? There is a small but influential faction of bloggers/financial talking heads out there that love to bash everyone who doesn’t invest exactly along their prescribed investment philosophy which is usually some sort of “passive” methodology, writing off non-conformists to their style as “forecasters” (or, even worse, “active managers”).
This is my favorite sort of debate, one in which I respectfully disagree with someone who is intelligent, credible and thought-provoking. A good debate makes you reconsider your position, refine your analysis and re-evaluate some of your assumptions.
Felder begins by saying “there is no such thing as ‘passive investing.’ Picking an asset allocation is, by definition, active investing.” I disagree, and would note that by avoiding stock picking and market timing, you have reduced 90 percent of what makes the vast majority of active managers underperform their benchmarks.
It is true that the classic 60/40 or 70/30 blend of stocks and bonds doesn't reflect real-world asset sizes -- the value of credit markets is far larger than the capitalization of equity markets. However, it is a reflection of Harry Markowitz’s "Modern Portfolio Theory." So any indexer must plead guilty on that count.
The reason I can't share Felder's conclusion is due to two main factors: the nature of human behavior and how we deal with the world of risk around us.
Further, a reasonable definition of forecasting makes it unlikely that everything is a forecast. We can agree that a forecast involves describing the price of an asset (or asset class) at a specific date in the future. When someone says the Dow Jones Industrial Average is going rise to 36,000 in 2005, or gold will be $10,000 an ounce by 2015, those are specific predictions.
By comparison, when my dog Max makes a leap in midair to catch a Frisbee, he isn't making a prediction. Rather, he has calculated the necessary steps needed to be in the right position to intercept a flying disc. The canine took a variety of data inputs -- the location and motion of the toy, his own relative position and his ability to cover distance at a given speed. Max can run those calculations in his head instantly, and catch the Frisbee.
Similarly, when you cross the street, you make lots of assumptions about the world without even thinking about it. You assume your entire visual field is accurate, that when you see no cars coming, there really are no cars coming, and that there isn't an invisible bus bearing down on you. When you hear the sounds of traffic, you don't consider them to be hallucinations. Indeed, you believe that you can make it safely across the street.
You make millions of these calculations per day. They occur almost automatically. But is it accurate to say you are predicting you will safely make it across the road? That renders the word "forecast" meaningless.
Lots of things in investing can look like a forecast, but really are not. As Felder noted, “If you tell me to own a total stock market fund over the next decade you are making a forecast about what sort of return you expect it to generate over that time.” Again, I disagree. It is easy to assume that everything you do about putting risk capital to work reflects a forecast that you will achieve your desired goal, but that is a gross over-simplification.
When I put risk capital to work, I am doing (at least) two specific things: First, I am making a probability assessment. What are the possible and likely outcomes for a given asset class, assuming an initial set of starting circumstances, and the effect of subsequent events that are likely to affect this initial state?
Second, I am assuming that the mathematical concept of mean reversion applies to asset classes. This means that over time, I expect cheap assets to become less cheap and return to their long-term average valuations and, conversely, expensive assets will do the opposite.
The entire concept behind “bashing forecasters” isn't simply to say that my forecast is more valuable than anyone else's; rather, it is to point out the futility of forecasting as a basis for making investment decisions.
I have no idea if equity investors will receive a negative real return during the next decade. I know some models generate that outcome, while others reach the opposite conclusion. I do know that none of these models have ever been tested with initial conditions remotely like these: A huge financial meltdown, six years of zero interest rates and minimal inflation or even deflation.
Regardless, I don't want to predict which of these models will be correct. Instead, I will continue to rely on probability assessment and the belief that all asset classes eventually revert to their mean.
The alternative is making a forecast. The evidence overwhelmingly suggests that the entirety of humanity has precisely zero skill in that regard and does no better than making random guesses.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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Barry L Ritholtz at firstname.lastname@example.org
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