Investors need to beware making predictions if they want to ensure they generate long-term returns, according to David Henry, investment manager at Quilter Cheviot.
Henry acknowledges that humans consistently overestimate their ability to predict the future, however, believes that recognising this isn’t anything to be afraid of. He says that knowing that the future is unknown and unknowable doesn’t just check the ego, it also forces investors to introduce a level of discipline into their investment process that can help in mitigating against worst outcomes.
Henry says we just have to look at the 2016 US Presidential election to see how wrong predictions can be sometimes. “The working assumption was that Hilary Clinton was going to prevail,” he says. “Consensus agreed that a Trump win would be bad for markets. We all know what happened of course. Mr Trump won the race for the White House, and US equity markets went on a tear – rising by 19% in 2017.”
He also cites the Brexit referendum as another example where market expectations were proven wrong after the vote to leave the European Union actually saw share prices go up after the initial shock due to sterling being weaker and company’s overseas earnings being ‘worth more.’
“Even if we are right about the outcome of a certain event therefore, it does not follow that ‘A equals B’. That is to say, that if “A” happens we cannot in advance necessarily determine the market reaction. To do so would rely on our ability to predict the reaction of hundreds of millions of market participants around the world to said news.”
To help investors guard against the worst implications of needless forecasting, Henry has produced five tips to follow.
1. Most things don’t matter
To state the obvious – if you make fewer predictions, then you are going to be wrong less. The vast majority of events simply don’t matter when it comes to the path of the stock market so making predictions is often futile. It may be difficult in a social media age, but none of us need to have an opinion on everything.
Making too many predictions can have worse consequences than just tying you up in knots. As we have seen, market reactions to events can be completely counter-intuitive. If you are making big bets based on a certain outcome, you can be right on the event and wrong on the market reaction. Which would be pretty infuriating I’d imagine.2. Maintain a laser focus on the long term
History, which is an imperfect guide but the best that we have got, shows that market returns become more predictable when we look back over longer time frames. While they naturally oscillate wildly over one year depending on how fortunate or not you are (the black line in below chart), annualised returns taken over twenty-year periods are relatively consistent (red line in the below chart).
Being a genuinely long-term investor therefore has two potential benefits: 1. Your likelihood of a positive outcome increases materially; and 2. The predictability of annualised returns increases too
Diversification may not be having a great year, but the best way to guard against inaccurate predictions is by having a collection of investments which are genuinely diversified within your portfolio. One of the most difficult elements of being a professional investor is that in order to embrace diversification, you will naturally have to add positions to your portfolios that you might not be all that positive on at any given time – maybe high quality short dated bonds, gold or commodities. You need to be prepared to hedge your base case. If you don’t, you are placing all of your chips on one number.
4. Be wary of narratives
If you have ever been on a sales course, you will know that people buy stories. If you are in the room with a particularly compelling salesman, it is easy to be swept up in a narrative.
Without getting into a debate about the merits of cryptocurrency, one thing that fascinates me about the asset is how evangelical its investors can be. Without a proven utility (which may arrive one day), the buy case can only be constructed based on narratives about the future which may or may not come to pass. Narratives which are pushed hard by those who truly believe.
Nonetheless, investments based solely on stories are dangerous beasts.
5. Recognise when you are wrong, and move on
People don’t like being wrong, but if you are investing in individual companies sometimes your investment thesis won’t play out. It can be tempting to dig our metaphorical heels in and entrench our position further in our minds – but this can be ultimately unhelpful. If you are in the position of investing in individual shares on your own behalf, try and set some rules in advance for these holdings that force you to reassess in certain given circumstances. Making rules for ourselves in advance can lead to better decision making when emotions are high.