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The Realistic Response to ‘Expert’ Optimists

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Mark Twain said that an optimist is a day dreamer more elegantly spelled. If Twain were alive today, he might add that an optimist is a financial expert who can’t see trouble, even though it regularly shows up.

Since 2000, Birinyi Associates, a financial research firm, has tracked the yearly forecasts of 22 financial experts at Wall Street’s biggest banks and investment firms. Every January 1, these experts, called “chief market strategists,” offer opinions on where the S&P 500 stock index will close on December 31. In addition to recording their individual predictions, Birinyi also calculates the average expectations of the group, as a way of assessing the general sentiment of professional investors.

Considering the variables that can impact the economy, no one expects the chief market strategists, even as a group, to have a perfect track record. But as economics and finance columnist Morgan Housel notes in a February 2015 article, “You might be surprised at how disastrously bad it is.”

Among the experts, optimism prevails. As a group, they have anticipated positive returns every year. And it’s not a case of two or three exuberant optimists skewing the group average; in 2015, every one of the 22 strategists was bullish. Yet four of the sixteen years produced negative returns, and two posted results close to zero. Down or flat years aren’t the majority, but they have occurred frequently enough that it would seem experts should occasionally predict down years.

The experts missed on the upside as well; positive returns significantly exceeded expectations in eight years, sometimes by 100 or 200 percent. In all, Housel calculates that the strategists’ forecasts were off by an average of 14.7 percentage points per year. Depending on where you live, your local meteorologist might be more accurate.

To hammer home the point that predictions from individuals with impeccable credentials and superior resources aren’t worth much, Housel compares their record to what he calls the Blind Forecaster: “He’s a brainless idiot who assumes the market goes up 9 percent—its long-term historic average—every year regardless of circumstances.” And guess what? By a narrow margin, the Blind Forecaster is more accurate; his degree of error is only 14.1 percent.

Poor economic prognostication isn’t limited to Wall Street and the stock market. Bankers and government economists follow the same pattern: They are relentlessly optimistic about the economy, and regularly surprised by downturns.

The Federal Open Market Committee (FOMC) is a Federal Reserve committee that determines monetary policy based on its assessment of the economy’s future prospects. On a quarterly basis, they issue a “Summary of Economic Projections” to elaborate. But much like the Wall Street market strategists, this group of bankers struggles to accurately anticipate the future. And they admit as much.

A research report published in February 2015 by the San Francisco branch of the Federal Reserve titled, “Persistent Overoptimism About Economic Growth,” found that: “Federal Open Market Committee participants have been persistently too optimistic about future US economic growth. Real GDP growth forecasts have typically started high, but then are revised down over time as the incoming data continue to disappoint.” Further, the report confirmed previous studies that showed “the record of failure to predict recessions is virtually unblemished.” Bad stuff happens, but optimistic experts never see it coming.

Government experts at the Congressional Budget Office (CBO) also acknowledge their shortcomings as predictors of future economic trends. However, they take some comfort in believing their errors are in line with everyone else’s. In their 2015 Economic Forecasting Record Update, using sophisticated statistical analysis, the office concludes that CBO’s forecasts generally have been comparable in quality with those of the Administration and the Blue Chip consensus. When CBO’s projections have proved inaccurate by large margins, the errors have tended to reflect difficulties shared by other forecasters.

Their math might be accurate, but there isn’t much comfort in hearing, “Hey, we might never get it right, but at least we aren’t more wrong.” The overwhelming conclusion remains: Financial experts are irrationally optimistic and ill equipped to spot trouble before it occurs. Which prompts two questions…

1. Why do people listen to forecasters who are so consistently wrong?

Housel weighs in: “I think there’s a burning desire to think of finance as a science like physics or engineering. We want to think it can be measured cleanly, with precision, in ways that make sense. If you think finance is like physics, you assume there are smart people out there who can read the data, crunch the numbers and tell us exactly where the S&P 500 will be on Dec. 31, just as a physicist can tell us exactly how bright the moon will be on the last day of the year. The belief that finance is something precise and measurable is why we listen to strategists.”

John Mauldin, a finance and economics columnist who regularly appears on the cable business channels, says people want to believe strategists because “the idea that markets are inherently messy and disorderly frightens them. It’s much more comforting to think that someone out there has a crystal ball that you just haven’t found yet.”

Mauldin adds another reason people listen to forecasters—they want a scapegoat: “The only thing worse than being wrong is being wrong with no one to blame but yourself. Forecasters keep their jobs despite their manifest cluelessness because they are willing to be the fall guy.”

2. Why don’t people make financial insurance a higher priority?

Think about it. These chief strategists, Federal Reserve committee members and CBO economists aren’t poorly educated con artists trying to fleece ignorant consumers. They have high levels of education, access to the best information and they want to do a good job. But if the smartest financial minds in the world can’t foresee economic peril, the only reasonable response is to obtain insurance.

This practical response seems to resonate when considering real assets like homes and automobiles. Nobody says “auto insurance is a waste of money” or “just skip it, you’ll probably never need it.” But the odds of the S&P 500 having a down year might be higher than your having a vehicular accident. In light of the inability of experts to avoid losses, doesn’t financial insurance make sense?

For most of us, financial insurance is about guaranteeing time and money. Remember the Blind Forecaster? His accumulation formula is simple: predict nine percent each year, and make regular deposits, through ups and downs, until personal experience matches the long-term average. Over the long haul, this steady approach can overcome the uncertainties that even the smartest people can’t see coming. But the problem for most people is their ability to stay in the game.

They don’t have the financial insurance that makes it possible to implement this incremental approach. They don’t have the “insurance” of safe or guaranteed assets, so they can’t withstand the losses from the inevitable down periods. They don’t have income insurance that would allow them to remain invested during a job loss, disability or even death. These financial instruments are available, yet often undervalued or ignored. You may not impress your friends with your “financial insurance plan,” but if you want the best chance to succeed in a world where even the best and brightest can’t see what’s coming, risk management is essential.

Optimism is a healthy, even necessary, character trait; negative people rarely achieve their dreams. But believing that someone really does have an economic crystal ball—and that they are willing to share it with you—isn’t optimism. It’s delusion. If you want to be optimistic about your long-term financial prospects, base it on a foundation of financial insurance.

How strong is your “financial insurance” program?

NOTE: S&P 500 Index is a market index generally considered representative of the stock market as a whole. The index focuses on the large-cap segment of the US equities market. Indices are unmanaged and one cannot invest directly in an index. Past performance is not a guarantee of future results.

By Elozor M. Preil

Elozor Preil, RICP®, CLTC is Managing Director at Wealth Advisory Group and Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). He can be reached This e-mail address is being protected from spambots. You need JavaScript enabled to view it . See www.wagroupllc.com/epreil for full disclosures and disclaimers. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.

 

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