You Are Never Hit By The Bus You See

With the stock market bouncing off all-time highs again, I’ve seen a large number of market forecasters making predictions about the future path of the U.S. economy and financial markets. If you enjoy hearing the predictions of the financial media talking heads, I implore you to take a look at CXO Advisory Group’s “Guru Grades” which has tracked forecasting accuracy for some of the more well-known market prognosticators. With this recent influx of market predictions, I thought I would take time to highlight some key points regarding market forecasts.

The IMF has a working paper that analyzed private and public sector forecasts leading up to different recessions. The IMF study found that forecasts made in recession years generally do not capture the start of the recession in a timely manner nor do they correctly estimate the magnitude. In other words, forecasters are slow to identify the inflection points that mark the start of a recession and they often incorrectly estimate the scope and size of the recession.

There are different theories out there to why this is the case. One is that forecasters don’t have enough information to forecast the recession ahead of time. While economic models are useful in providing the construct and basis for a prediction, they are not fool proof. One of the main limitations regarding economic models is the fact that some economic shocks are difficult to anticipate and model, hence the title of this blog post.

Another reason to consider is that maybe economists aren’t incentivized to predict a recession. The costs of straying from the consensus opinion on the markets and making a bold prediction that could turn bad may outweigh the benefits of making such a prediction and being right. This reputational risk and career risk needs to be considered when evaluating a forecaster’s predictions.

Finally, past studies have found that forecasters tend to hold on to their previous beliefs for too long and are slow in synthesizing new information into their forecasts. This could explain why forecasters are slow in identifying the inflection points of a recession as they are slow to update their predictions when new information becomes available.

So which financial media talking heads are worth listening to when looking at the long term goals of your portfolio? I would argue that none of them are worth listening to. The reason for this is that financial planning success isn’t predicated on being able to sidestep a market correction. Rather, it is predicated on being disciplined in saving and investing over long periods of time.

All comments and suggestions are welcome.

Paul Warholak, Jr.