En español | This time of year is also the season for financial predictions. One recent article offered an assortment of pundits telling us precisely how the S&P 500 index will perform next year. All this prognostication feeds our addiction to prediction, which, unfortunately, also can compel us to make bad financial choices.
But no matter how often the crystal ball malfunctions, our human desire for certainty has us coming back for more. How many experts do you think predicted a more than 38 percent loss in the S&P 500 in 2008?
While less emotionally compelling, predictions that give a range of probabilities and an understanding of the consequences of market outcomes provide better insight into the future. Consider my predictions for 2019:
1. Stocks will earn 7 percent, with a range of down 21 percent to up 35 percent.
Using some statistical analysis, I’m 95 percent confident of this range, which I based on historic volatility and lower historic returns based on current rich valuations. The implication is that stocks are great for very long-term investing but are risky.
My gut feeling is that volatility will be greater next year, so the down side could easily be more than a 21 percent loss. Look at the consequences of a possible market plunge to your life to decide how much you should allocate to equities. Make sure you can stomach such a potential loss.
2. High-quality bonds will earn 3.4 percent with a range between down 3.1 percent and up 9.9 percent.
I have about the same 95 percent confidence since the current yield is the best predictor of total bond return and I’m also using historic volatility. Thus, the less you can afford the higher volatility of stocks, the more you want in high-quality bonds.
3. Investors will sell what has underperformed to buy the asset class that has performed the best.
Though I never claimed to be able to predict markets, human behavior is so predictably irrational that you could set your watch to it.
Like heat-seeking missiles, we target whatever hot asset class has done the best. If stocks tank, bond funds will see money moving in. If stocks soar, bond funds will be shunned and money will flow from bond funds back to stock funds. In fact, whatever narrow portion of the market performs the best will then see money moving into those funds.
The consequences are that you are selling low and buying high, which, in the long run, is likely to underperform. Don’t do it.
4. New products and strategies will be launched in 2019 and heralded as having worked in the past.
The technical term is “backtesting,” which tells you how you would have done had the new product actually existed years ago. Unfortunately, that’s only valuable if you have access to a wormhole that will enable time travel.
When you think about it, that’s just another form of buying high after something has performed well. Examples include “smart beta” funds and master limited partnership funds that were sure to outperform the overall market, until they didn’t. Don't invest solely based on past performance.
5. No one will tout how poor their past predictions were.
Here I can raise my confidence level to over 99 percent. If “experts” touted their mistakes, they wouldn’t be held as market gurus any longer. So if you are going to invest based on the brilliant logic of these pundits, first do a Google search to look at their prior predictions and see how well they turned out.
It’s natural to want to know the future and be in control of our own destiny. It’s also natural to want the products and strategies that have performed well. But these natural instincts fail us when it comes to investing. Here’s more information on an academic study of forecasters’ accuracy you should read before betting your future on any financial guru.
A much better option is to look at the ranges of returns and understand the potential consequences of the outcomes, both economically and emotionally. Even if you can afford the economic loss, we underestimate the emotional toll that drives us to panic and sell when stocks plunge.
Accept that stocks have a higher expected long-run return than bonds but are many times riskier. Resist the temptation to invest based on past performance. And, finally, no matter how compelling the logic, don’t even think about investing based on a financial guru’s specific predictions in a very risky world.