John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the Omega Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
When will the U.S. Federal Reserve Board begin tapering its huge, market-bolstering quantitative easing efforts? How will Europe's lingering debt woes play out, and how will that impact markets in North America? Where will the S&P/TSX composite be at the end of 2013? How about the S&P 500?
Pundits and analysts have been – and will keep on – debating those questions, offering confident, seemingly well-reasoned answers every day across the airwaves and Internet. And, though hordes of investors will keep following their advice, the vast majority of those pundits will be wrong.
Want evidence? Consider the research Philip Tetlock detailed in his 2005 book Expert Political Judgment: How Good Is It? How Can We Know? Mr. Tetlock, a professor at the University of Pennsylvania, conducted a seven-year study in which both "experts" and "non-experts" were asked to predict an array of political and economic events. The study looked at more than 80,000 predictions, and it found that, while the experts fared better than non-experts, they didn't live up to what most people expect from them. In fact, their predictions on average explained only about 20 per cent of outcomes.
In the financial world, forecasts are ubiquitous, and they play a huge role in driving the stock market. An analyst's estimates for a particular company's quarterly earnings are often taken as gospel, for example. If the company falls short of the estimate, shares often get hit hard; if it beats expectations, they often jump. But as David Dreman, the Toronto-born money manager whose writings are the basis of one of my Guru Strategies, has noted, analysts miss the market far more than they hit it. In his book Contrarian Investment Strategies , Mr. Dreman detailed research showing that "there is only a 1 in 130 chance that the analysts' consensus forecast will be within 5 per cent (of actual earnings) for any four consecutive quarters." In other words, he said, "Your odds are ten times greater of being the big winner of the New York State Lottery than of pinpointing earnings five years ahead."
A myriad of other studies have shed light on the difficulty of predicting future earnings or stock returns – and it's not just analysts who fall short. In a paper released this year, Urooj Khan, Oded Rozenbaum, and Gil Sadka of Columbia University said that, unlike analysts' estimates, forecasts made by company management do tend to incorporate all information embedded in prior stock returns. Nonetheless, management forecasts are more "optimistically biased" and no more accurate than those of analysts, the study found.
But whether it's analysts or corporate managers or individual investors(whose collective track record of predicting market movements is dreadful, studies show, it's hard to cast too much blame on any one group. Making predictions about the economy and markets is hard. In addition to our own biases , you must deal with a seemingly endless parade of intertwining variables. Making accurate predictions in recent years would have required that you'd understood the machinations of the U.S. housing market and mortgage-backed securities, that you'd have been able to predict how governments around the world would react to the housing and financial crises, and that you knew to what degree investors' psyches would be bruised by the crises, and when they'd begin to heal. That doesn't even include international issues, such as how China's slowdown would turn out or how and when the European debt crisis would flare up.
If you were able to predict all those things, my hat's off to you, because even the world's most successful investors weren't able to do so. In fact, great investors' true wisdom lies not in an ability to forecast short-term events better than others, but in their decision not to play the forecasting game.
Warren Buffett, for example, often talks about how no one knows what's going to happen with the economy or market in the short term. "We've long felt that the only value of stock forecasters is to make fortune tellers look good," Mr. Buffett once wrote in a Berkshire Hathaway annual letter. "Even now, Charlie [Munger] and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children."
How to play the game differently
How, then, do Mr. Buffett and other successful investors make money? In the dozen-plus years I've been researching history's best investors, I've found that most share some key similarities that separate them from the masses:
They think long-term;
They keep emotion at bay (as much as possible);
They focus on value.
Mr. Buffett and other greats such as Peter Lynch, Joel Greenblatt, and Benjamin Graham aren't swayed by analysts' forecasts or pundits' predictions. They have ways of analyzing companies, digging into their balance sheets and fundamentals, and they look for good businesses whose shares they can buy on the cheap. Often, these companies have short-term clouds hanging over them – that's why their shares are cheap. But while other, more emotional investors get caught up in short-term negative headlines, these gurus look at the long-term potential, and they stay patient. They know that it can take time – months, sometimes even a year or two – for the value they see to be recognized by others. But they know that at some point, the odds are they'll be rewarded.
These broader concepts may be more important than any analytical strategies that Mr. Buffett and other greats use; indeed, all the gurus who inspired my strategies focused on a unique set of specific variables. Their mindsets however, were very similar – and in most cases short-term forecasts didn't enter into the equation. The next time you think about buying or selling stocks because of an "expert's" predictions, remember that.