Hi Guys,
Some historians have written that the US in the way General Ulysses S. Grant signed his name stood for Unconditional Surrender. During the Civil War, when terms were negotiated, Grant summarily and succinctly demanded unconditional surrender. Upon deeper reflection, he often made generous concessions to his worthy adversary.
Well, it’s that time of the year when forecasts of portfolio likely returns are encouraged and made. With regard to my investment portfolio, I have been making an annual performance projection for over two decades. Over that period, my methodology has become more sophisticated, more arcane, as I added economic and business factors to the analysis to better capture market dynamics. The additional complexity did not improve my forecasting accuracy, which in general, registered an abysmal record.
So, given my dismal prediction scorecard, and some incremental wisdom that experience and further book learning rewarded me, I have decided that an unconditional surrender is warranted on the forecasting frontlines. I choose not to make a next year anticipated return prediction. I have been humbled by history.
That decision does not equate to abandoning the marketplace. Although experience has eroded my confidence in making intermediate-range market forecasts, I still trust the vitality of free markets to generate rewards, and the meaningfulness of statistical data sets to get long-term average returns approximately correct.
Over the long haul, stocks deliver better returns than bonds, and diversification works as a risk mitigation tool. So some portion of my portfolio will remain with equity mutual fund holdings although I am definitely in the drawdown stage of my lifecycle. Additionally, statistical data suggests a solid positive return from a Presidential 4-year cycle data analysis.
A recent academic analysis of stock and bond returns from 19 countries and covering an 110-year period supports that decision. The paper that reports these findings is titled “Stocks, Bonds, Risk, and the Holding Period: An International Perspective”. I have appended a Link that permits an immediate download to it as follows:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1971095The paper concludes that time diversification works wonders, and, over longer timeframes, ownership of equities is less risky than bond holdings The study used several different standard measures of risk characterization. Returns are provided in real terms so inflation within each country is subtracted from the actual returns. Here are several quotes lifted from the study that cogently summarize the author’s conclusions.
“The longer is the holding period, the higher is the uncertainty about how large the
accumulated wealth will be at the end of that period. But it is essential to notice that most of this increasing uncertainty is ‘upside risk.’ ”
“(I)n the short term stocks are riskier than bonds; this is the case regardless of the type of returns (annualized or cumulative) on which investors focus and the way they assess risk (generally as uncertainty or more narrowly as downside potential). The evidence also shows that in the medium to long term stocks become less risky than bonds; this is clearly the case if investors focus on annualized returns, and largely the case if they focus on cumulative returns.”
In six of the 19 countries (Belgium, Finland, France, German, Italy, and Japan) bonds delivered a negative annualized real return. Bond returns in these six countries did not keep pace with inflation; now that’s a sorry state that inflicts the US in some bond categories.
Over the last two months I have focused my studies on Behavioral research, Complexity modeling, and Chaos Theory. I have read Daniel Kahneman’s “Thinking, Fast and Slow”. Melanie Mitchell’s “Complexity: a Guided Tour”, and James Gleick’s “Chaos, Making a New Science”. All are accessible reading for the non-scientifically trained among us. I recommend all of them. I am currently viewing The Great Courses DVD series titled “Chaos” presented by Professor Steven Strogatz. It’s stimulating stuff.
The overarching takeaway from this ensemble of coupled disciplines is that forecasting future market returns is both troublesome and futile. The dice are loaded against any soothsayer, private or institutional; gurus prediction records confirm their poor performance history.
The marketplace is dominated by surprising nonlinear relationships with complex, interactive feedback loops. Overall, human behavior might be prudent, the heralded wisdom of the crowd myth, but certainly at the individual, investor-agent level, human decision-making behavior is not only not rational in many instances, it is also in a dynamic, constantly ever-evolving mode. That’s one plausible explanation for booms and busts; panics happen.
Although these scientific disciplines are relatively immature, some of their discoveries cause pause with respect to the usefulness of detailed market studies and modeling. Predictions are suspect and must always be interpreted with skepticism.
For example, one major insight that Chaos researchers have verified is that nonlinear, interactive systems (like financial markets) are hypersensitive to something called Initial Conditions. When solving any differential equation or when running any numerical computer simulation, the researcher or investor must input a measured or estimated starting value set of parameters. The Chaos guys have demonstrated that final results are extremely dependent upon these starting conditions to a degree that challenges measurement accuracy or foreknowledge.
A seminal computer global weather forecasting model developed by MIT meteorologist Edward Lorenz illustrates this sensitivity. Even his simplified model of the global weather generated extremely disparate weather projections when inputs that varied in the eighth decimal place were peryurbed as starting conditions to test the robustness of the modeling.
That accuracy demand is well beyond any measurement capability today or tomorrow. Small changes produced huge differences in the weather final predictions. It is an illustration of the “Butterfly Effect”. Think about what that sensitivity to inputs means in an investment scenario. It is an impossible task when attempting to secure any reliable forecasting results. That’s why many meteorologists have abandoned their quest for a reliable long range weather forecasting tool; that’s why I elected to forego a 2012 market returns estimate.
Even simple mechanical systems have the potential for chaotic performance. The difficulties of forecasting a trajectory and a final resting place can be clearly demonstrated by simple mechanical experiments conducted with single magnetic pendulum and double-pendulum systems. With very minor perturbations, a final resting position for a single magnetic pendulum device can be easily projected. But even a relatively benign nudge outside that band can completely destroy that predictability and make the event look random.
I have appended two Links that nicely illuminate these unexpected phenomena using both mechanical pendulums and computer simulations. Hundreds of these short videos are available on the Web. Have some fun with them.
And Kahneman’s book demonstrates over and over again how we make biased and disastrous individual decisions because of faulty and incomplete utilization of the reflective, thinking portion of our brain to temper the vicissitudes of the reflexive, emotional portion of this highly complex body organ.
In the end, I find the task of making an annual projection for next year’s probable portfolio returns a fool’s mission with unlikely usefulness. So, this year, I abstain from that mission.
That does not mean that I will forsake the financial marketplace. I will make a few minor changes to my portfolio with confidence that, in the long run, the marketplace will reward my patience and persistence with returns that I can not obtain anywhere else.
Allow me to close with a quote from Peter Bernstein: “If diversification is the prime method for improving the trade‐off between risk and return, then diversification over time is just as important as diversification across asset groups at any given moment.”
Merry Christmas to All.
Comments
You noted, "So, given my dismal prediction scorecard, and some incremental wisdom that experience and further book learning rewarded me, I have decided that an unconditional surrender is warranted on the forecasting frontlines. I choose not to make a next year anticipated return prediction. I have been humbled by history."
Ah, heck........take your best guess.
I will...........................the year of 2012, as viewed from the Ouida board and Magic 8 ball questions.
---U.S. An election year, full of drama. Congress will remain in a tizzy. Promises, as usual, will abound from the candidates. From an '80's pop song....the theme will again be; "clowns to the left of me, jokers on the right; here I am, stuck in the middle with you".
Joe and Jill consumer have had a fling with money many really don't have, except in the plastic form; this holiday season. The consumer is just itching to buy something; no matter what, as old habits are hard to break (the behavior part). Consumer spending, except for what is needed for living will retreat by February, 2012. This will cause problems for some company profits in these areas.
At least in Michigan, personal taxes are going up in 2012. The Republican lead charge on this is to offset a loss of business tax revenue from the restructing of the business tax code. Basically, the Republicans want us to share the sacrifice to build a better MI and attract businesses to MI. When the winter weather passes; we citizens will be expected to stand with placards upon on our chests, at all state border entrances to announce that each individual taxpayer in MI is giving up some of their monies and putting it in the hands of any business that chooses to move to MI. OKAY, that sure sounds like a plan, eh? I am a think'in that the computer program model for this has a few bugs. I assured the MI guberment kids that for every dollar they choose to remove from my pocket will not be spent at local businesses; a continued pullback with consumer spending. The current MI guberment kids know why the numerous large companies have not moved to MI over the past 20 years, and are now parked in the southern states and providing jobs there; but they are to "chicken" to come out in the open to admit the real situation.
---Global..... The Middle East area will find new and continued problems, which will affect crude oil pricing to the upside. China may get caught in an export pinch; as growth continues slow in the developed market countries sorting out their numerous problems.
From these most simple thoughts; of which, I will have to return to this write to addend; as the thoughts emerge, may bring forth the following:
---Equity markets will not suffer more than a -27% decline from closing levels at the end of 2011; before the traders and machines move in to drive equity markets up; at least for a few months. 'Course this may place some global equity sectors into the -50% retracement for a year over year period, which began in 2011.
---Bonds 10 year/30 year Treasury issues will hit yields of 1.44% and 2.56%, respectively. In spite of U.S. debt again being downgraded, this area is still the best of the turd piles, globally speaking of bonds; with possible exceptions being the German bund, but more likely the UK gilt.
---Other Gold will hit $2,750/oz.; in spite of the U.S. dollar index advancing 10%, with gold being fueled by $135/barrel crude (Middle East problems). Consumer spending will take another hit, as any extra cash will have to used to buy $5.25/gallon gasoline. The Euro will move from about 1.30/U.S. today, down to 1.09. Emerging market countries will have to reduce internal interest rates in an attempt to stimulate their economies.
Now, if I can just get the time frames of events in place for the investments !
All of this piled upon the Mayan End of Days in December, 2012; which may find holiday shopping in the U.S. as a non-event....:):):) Some scientific folks may survive the E.O.D.'s to attempt to discover what really happened.
Well, that was fun; and I may return for add-ons.
Take care,
Catch
Hi Catch,
Wow, that’s a gutsy forecast for the 2012 equity market returns. It certainly is running against the winds of history.
You modestly claim that it is a guesstimate. If it is solely a guess, it is better characterized as a wild guess since it differs dramatically from the historic returns data sets and is so threatening to portfolio health.
Since some of your posting is committed to projecting global trends that will surely impact the marketplace, I suspect that your forecast embodies something more then pure guesswork; it has some assessments, even if highly speculative, that directs you to a gloomy prediction. Those global judgments do not seem that dire from my perspective. Are you adjusting your portfolio to reflect this ominous estimate?
If portfolio management were analogous to a dice game, your 2012 forecast would be like betting on a snake eyes (a two) outcome. The odds of you being right on this matter are extremely long indeed.
Equity market returns are not only rarely as negative as you forecast, they are positive about 70 % of the time on an annual basis. In the election year of the Presidential 4-year cycle data set, average returns are slightly better then the all inclusive average annual returns; the data show an even more positive likelihood when the incumbent is running again to retain his office.
An equity market return of the negative nature that you guesstimate has been rarely recorded; it has happened like 18 percent on an annual basis since 1871. The equity marketplace has delivered negative returns in excess of -10 %, -20 % and -30% only 13.9 %, 3.6 % and 2.2 % of the time, respectively. The maximum annual down equity return registered was about -44 %.
Even allowing for a fat-tail distribution profile, you are betting on a long shot (given the season, perhaps a Hail Mary would be a more apt description). Have you adjusted your portfolio accordingly to profit if it is indeed realized?
If not, it is a waste of time and energy, a useless meaningless exercise, as I stated in my original Unconditional Surrender post.
Best Wishes for a Merry Christmas and a Happy New Year that does not see the fruition of your fearless forecast.