As human beings, we are hard wired to tell stories about our experience. Applying tidy narrative structures to often random events helps us to feel we can make sense of the world. And this impulse tends to really kick in around the end of the calendar year when we’re taking stock.
Tapping into this tendency, media outlets populate their year-end editions with stories that seek to build catchy tunes out of noisy reality. In the financial media, the set narrative is applied to investment. So we’re told this year has been all about “x” and next year will be all about “y”.
Annual investment outlooks and media round-tables about the year ahead can be entertaining to read, of course. Everyone has a right to their opinion, and some professional pundits can be adept at telling convincing sounding stories about the future that resonate with readers. But problems can arise when individual investors act on those forecasts, overlooking how much each scenario is dependent on a whole host of other assumptions. Ultimately, the world is much more complex than any conventional narrative can accommodate.
For instance, each year around this time The Australian newspaper publishes its “Top 100 Picks”1 for investors in the coming 12 months. Inevitably, there are some winners in the “collected wisdom” of the journalists and contributors, but there are also plenty that miss the mark.
Often these picks are based on a view about a particular sector. So we were told a year ago that Moko Social Media (MKB), which builds smartphone apps, would be a “cool dude” investment for 2014. Cool perhaps, but not in a good way. As of early December, Moko’s one-year return was -45%.
Not deterred by its disastrous picks in the gold sector the year before, the newspaper doubled down in its 2014 outlook, singling out miner Beadell Resources (BDR) as one seen as “absurdly undervalued”. Well, perhaps not by enough, as Beadell was down by 73% a year later.
Elsewhere among miners, The Australian saw exciting prospects for Guildford Coal (GUF). But perhaps the panel didn’t count on the 15-20% slide in coal prices in the intervening year as the stock had delivered a one-year return of -51% as of early December.
In the gaming sector, the newspaper’s forecasters picked two stocks. One of them, slot machine maker Aristocrat Leisure (ALL), delivered with a positive return of 45%. But the other pick, rival gaming machine maker Ainsworth Game Technology (AGI), fell 50%. Call it a 50/50 bet then.
Ultimately, it seems clear that investing this way (judging the future prospects of individual companies) is a bit of a crap shoot. You’ll get some calls right and others wrong. And even your good calls, based on the individual company information, can come undone due to outside influences.
For instance, resource companies can be hostage to the commodity price cycle. Retailers can be influenced by changes in household spending patterns and the macro economy. Regulation and interest rate cycles can influence the fortunes of financial services companies.
So even if you carefully study each company’s management, product range, industry position, balance sheet, analyst ratings and all the other variables that influence its outlook, there is still no guarantee you will get it right. There are just so many variables to consider.
We have seen that “bottom-up” forecasting (judging the outlook for individual securities) is notoriously difficult. But top-down forecasting (picking the movements of big economic variables) isn’t easy either.
In January of 2014, The Sydney Morning Herald asked a panel of six economists their forecasts for cash rates, the $A and shares. While their forecasts for the currency and shares were broadly correct, all six predicted cash rates would rise. As of yearend, though, the cash rate remains at 2.5% and the market increasingly expects the next move to be down2.
It seems pretty clear, then, that basing your investment strategy upon the forecasts of share analysts, economists and journalists about the outlook for individual companies, sectors, industries and the broader Australian and global economy is a dicey proposition.
So what can you do? First, you can start by accepting that all those views about the outlook—from the rosy to the gloomy—are already reflected in market prices. Some people will get it right sometimes. Others will get it wrong. But the winners and losers are changing all the time.
This is no reflection on the skills of forecasters, by the way. Their cases may be based on first-rate analysis. But because they can’t forecast every variable and because new information is always coming into the market, their assumptions can quickly go awry.
The alternative to hitching your fortunes to a forecaster is to harness the collective information already built into prices, which are always changing as news develops. By the time you have spent days and weeks poring over forecasts, the market has already moved on.
The second thing to do is diversify. Will Australia outperform global shares in 2015? Will interest rates rise? Will they fall? Has the Australian dollar bottomed out? Will mining stocks recover? What will drive growth domestically? How about internationally? Which sectors will perform best?
The truth is no-one knows the answers to these questions with any confidence. We see that over and over again. So the smart response is to spread your risk. Some sectors will do well next year. Others will do badly. As we don’t know which is which, we can own a bit of each of them.
The third thing to do is to focus on things you can control. Costs can make a huge difference to investment outcomes, as can taxes. What matters to you ultimately are not just the returns from your investments, but what is left in your pocket after fees and taxes.
A final reminder is to regularly rebalance. That just means ensuring your allocation to various asset classes remains in line with your original targets based on your risk appetite and goals. So if shares have had a bad year and bonds a good one, you might take some money out of the strong performer and reinvest into the underperformer. This means you are selling high and buying low.
Most of all, keep in mind that risk and investment go hand in hand. No investor can expect greater returns without bearing greater risk. As we don’t know when risk will be rewarded, the best approach is to stick to the plan you decided on with your financial advisor.
It’s in our nature at the end of the year to look back on the last 12 months and project possible outcomes for the coming year. The danger, as we have seen, is in investing our own money in a forecast that assumes the world is much less complex than it really is.
Letting go of the idea that successful investment comes from making accurate predictions about the market and economy can free you up to focus on what is within your control—like asset allocation, diversification, costs, taxes, discipline and rebalancing. In the meantime, many happy returns!
1. ‘The Top 100 Picks for 2014’, Tim Blue, The Australian, Dec 28, 2013
2. ‘Familiar Pattern to the Year Ahead’, David Potts, SMH, Jan 15, 2014
Article by Jim Parker as part of his Outside the Flags collection.