The Fallacy of Forecasting

Growing up in an unpredictable climate with a weatherman whose talents were commensurate with the local TV station’s budget, I learned early on that I only need to wake up and look out my window to determine if the game was on or not. My low-tech approach made sense for years. But my strategy—and the jokes about weather forecasters—may one day be a thing of the past.

It is simple to see what “is.” But to predict the future, we need complete understanding of the elements that play into the possible outcomes. Miss any one and your forecast will be off, if not completely wrong.

Forecasts for weather are actually getting more accurate. Three-day forecasts today are as good as 24-hour forecasts were in the 1980s, and the average error in hurricane-tracking predictions has been slashed by two-thirds since the early 1970s.¹

This improvement is a result of computer models that collect all the data—temperatures, clouds, and winds—and put it into mathematical equations. These models were built by looking for and identifying variables that offered some predictive value. Over time, as more of these factors were identified and fed into the model, the accuracy of the forecast improved.

We have been attempting to do the same thing with the stock market. We have spent endless amounts of time, money, and human capital trying to identify variables that help predict market behavior. We have looked at the ridiculous (NFL Champions) and the more serious (past performance). Still, none of them have much predictive value, particularly over the short term. But that doesn’t stop us from looking, which often leads to guessing. And guessing is no way to make investment decisions.

The pioneering investor, Ben Graham, is said to have described the market as being hard to predict: “In the short run, the stock market behaves like a voting machine, but in the long term, it acts like a weighing machine.” And because humans are doing the voting, it’s very difficult to predict which way the vote will go.

Another reason is that investing is not a physical science. It’s not like gravity or even the weather. It doesn’t follow set laws. On any given day, the stock market represents the collective feelings of all of us. More often than not, those feelings are based on fear or greed. And it is only in hindsight that we recognize our mistakes.

So while on one level, human behavior seems predictable (e.g., we get excited and buy stocks when they are flying high; we get scared and sell when stocks decline), it’s awfully hard to know what we’re doing until it’s too late.

The temptation to make investment decisions is heightened when the market is trading at highs and lows – emotionally. But the chart (left) shows how much missing a small number of the best performing market days could cost investors. Over the past 15 years, if you missed just ten of the best-performing days of the market, you missed out on a 149% return, or a 6% annualized return. And, if you were not invested during the 30 best days, you may be worse off than investing at all.

There is no proven, market-predicting model hidden in a computer that only a few people have access to. The best we can do is learn from the past and put the market into a series of probabilities.

The facts have remained the same. Over time (think 5, 10, or 20 years), stocks typically do better than bonds, and bonds typically do better than cash. We also recognize that we will experience volatility and that short-term returns have a wider set of outcomes. Thus, we can control these short-term fluctuations through segmenting cash we know we need for short-term outflows from those invested in longer-term (higher probability of success) strategies.

So, forgive me for skirting your questions when asking about where we think the market will be in the next 6-12 months because the honest answer will always be, “I don’t know.” And the question that really matters is, “When do you need your money?” We replace forecasting with “aft-casting” – using what is happening now (or recent past) to inform what we should do rather making decisions on a multi-outcome, unpredictable and unknown future. This is where utilizing “buckets” to segment your assets based on when you need money is so important. For those of you whom we work with, we have the time (and the cash) to see this current market pullback through to the other side. And keep the faith that we will see the other side!

Sources

1. American Geosciences Institute: How has the weather forecasting changed over the past two hundred years?

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Josh Miles and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including asset allocation and diversification. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions.