The dubious value of market forecasts | The Informed Investor

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Market forecasts exert a strong pull on many investors. Even if they know enough to realize that no forecast is a sure thing, many investors have an irresistible urge to “do something” in response to the forecasts of market or investment experts. Following the advice of experts would seem to be a sound technique. The data, however, tells a different story when it comes to experts’ forecasts.

Market forecasts are fodder for the financial media. Presented by authoritative experts or colorful personalities such as Jim Cramer, forecasts draw an audience. Even many investment advisors fall under the spell of a favorite market guru. Some advisory firms issue regular commentary discussing market indicators and trends which are suggestive of where they think the markets are heading even if they are not explicitly issuing a forecast.

Forecasts can be interesting, logical and packed with data, but study after study shows that they do not reliably add value for investors. Making investment moves based on forecasts is a form of market timing. Unfortunately, the reliability of forecasts is virtually indistinguishable from flipping a coin.

One study called “Guru Grades” reviewed the forecasts of 68 market experts concerning the U.S. stock market over an eight-year period from 2005 through 2012. The experts they tracked covered a range of views from bulls to bears and based their forecasts on a range of indicators including fundamental and technical analysis. Some experts had high profile names, others were relatively obscure.

The average rate of accuracy across all the experts was 47%. The distribution of accuracy rates by expert looked very much like a bell curve, a normal distribution of random variables. Accuracy ranged from a low of 20% to a high of 68%. To fully assess the merits of a study, it’s important to understand the methodology used, something that is beyond the scope of this article. On its face, however, this study offers no support for the notion that expert predictions can reliably add value for investors.

A subsequent study did a more robust analysis using the same data set as the “Guru Grades” study and yielded slightly more nuanced conclusions. It was found that most forecasters had even lower rates of accuracy but that a small number of forecasters did significantly better than previously reported. Four of the sixty-eight experts hit accuracy rates approaching 80%. That is impressive performance by a few experts, but the study sheds no light on how the alpha experts could be identified in advance, whether their performance can be attributed to skill or luck, or whether their superior performance persisted over time.

There are a host of similar studies reaching similar conclusions about the inability of most experts to produce reliable forecasts. Let’s consider just one more, this one dealing with interest rates, another favorite topic of speculation. This study looked at the accuracy of forecasts by economists concerning interest rate changes, both the direction and magnitude of change, over a twenty-year period, 1982-2002. The study concluded that the forecast accuracy of economists for Treasury bill rates was statistically indistinguishable from a random distribution and that the forecast accuracy for Treasury bond rates was significantly worse.

Even the Federal Reserve has a poor track record predicting short-term interest rates. Keep in mind that the Fed sets the Fed funds rate. In 2022 the Fed increased rates more than twice the number of times they forecast at the start of the year and ended the year with a Fed funds rate that was more than four times higher than predicted.

Why do so many investors and even advisors attach such weight to market forecasts?

1. Confidence sells. Data conveys authority and authority projects confidence. I once heard the CEO of a public company comment self-deprecatingly about his own business acumen: “often wrong, but never in doubt.” The same could be said for most market forecasts.
2. Confirmation bias. We are all susceptible to opinions which confirm our own beliefs. If a forecast confirms our own market hunches we are more apt to agree with it and act upon it.
3. A bias against passivity. Many people trained for leadership are taught to take the initiative and to be decisive. “Don’t just stand there, do something.” John Bogle, the founder of the Vanguard Group, was fond of flipping this on its head. Faced with a relentless flow of market data and other news, he believed that investors should tune out most of this. He would say, “don’t do something, just stand there.” What appears to be a well-founded investment decision is more likely to be counterproductive and what appears to be passivity may in fact be discipline.

Investors should be wary of incorporating any expert’s forecast into their investment strategy. Forecasts may have entertainment value but their investment value is dubious. Clients will occasionally ask what we think about this or that topic as it relates to possible market or economic outcomes. We always preface our reply by saying that what we are about to say is just our opinion and it is not actionable. We are not going to make any portfolio changes based on our or anyone else’s forecast. Instead, we are going to fall back on the discipline of our previously adopted investment plan, unless there are other reasons to change the plan.

Far better to stick to a good plan than to make unforced errors in search of the perfect plan.

David Peartree JD, CFP® is an investment advisor with Brighton Securities Capital Management. This column is a collaborative work by David Peartree and Patricia Foster, Esq. Patricia Foster is a securities attorney with Harris Beach, PLLC focusing on the financial services industry. The information in this article is provided for educational purposes and does not constitute legal or investment advice.