Bards of the Bar

By Jim Parker

As a topic of conversation, investment is like sports. Everyone has an opinion. And the strongest opinions often come from those who spend more time in front of the TV than out on the field. Practitioners, meanwhile, are wary of anything labeled a sure thing. Indeed, it's one of life's ironies that the people who know the least about a subject sound the most sure of themselves. In investment, these are the ones who prop up bars telling anyone who will listen that they have found the path to certain wealth.

These pub philosophers tend either to be permanent bulls or permanent bears about the market. They have their standard story, and they adapt the facts to fit. Some of them even end up writing newspaper columns and hosting television shows.

By contrast, some of the world's most respected and seasoned investors strike a humbler tone, having learned from personal experience about the unpredictability of markets and deciding to focus instead on those things within their control.

Take, for instance, the frequently heard line that smart investors should seek to time their entry points to markets and wait for the volatility to clear. We are hearing a lot of that right now as the European crisis dominates market attention.

Writing about this in 1979 before one of the biggest bull markets in history, Warren Buffett said: "Before reaching for that crutch (market timing), face up to two unpleasant facts: The future is never clear [and] you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values."¹

Another line from the pub philosophers is that the job of an investment expert is to spot the best market-beating returns and harvest them before someone else finds out.

Asked about this in 2007, two years before his death, legendary investment consultant and historian Peter Bernstein said it was better to focus on risk than return. "The central role of risk, if anything, has grown rather than diminished," he said. "We really can't manage returns because we don't know what they're going to be. The only way we can play the game is to decide what kinds of risk we're going to take."²

A third perennial pub conversation is the role of stock picking in investment success. The line here is that the key to wealth building lies in painstakingly analyzing individual stocks and buying them based on a forecast or even a hunch about their prospects.

Prompted by a newspaper reporter for his opinion on that piece of conventional wisdom, Charley Ellis, long-time Wall Street observer and the founder of Greenwich Associates, said the truth was actually quite the opposite.³

"The best way to achieve long-term success is not in stock picking and not in market timing and not even in changing portfolio strategy," Ellis said.

"Sure, these approaches all have their current heroes and war stores, but few hero investors last for long and not all the war stories are entirely true. The great pathway to long-term success comes via sound, sustained investment policy, setting the right asset mix and holding onto it."

While that's probably not the kind of message you are likely to hear from the instant experts who prop up your local bar, it may be a more durable and a more useful one.

The Paradox of Skill

By Brad Steiman

Statistical significance is extremely important when drawing conclusions from noisy data. Noise in the data is problematic when investors overemphasize what might have been a period-specific outcome rather than a robust and repeatable result that is likely to persist going forward. Manager selection is a process that requires analyzing noisy performance data, so it should lean heavily on the notion of statistical significance.

When advisors, consultants, or investors select a manager, their approach often involves a combination of qualitative and quantitative analysis. The latter, by necessity, requires the use of past performance, as it is essentially all we have to evaluate. The focus is typically on managers with a positive "alpha" (i.e., outperformance relative to a benchmark or asset pricing model). Although past performance represents what actually happened, new investors cannot get those returns; therefore, the objective of the analysis is to determine whether outperformance in the past is any indication of skill, or simply good luck. In other words, is the positive alpha likely to persist in the future, after the manager is selected?

This task is more difficult than many investors might think. Several notable studies of manager performance found little persistence in past performance.¹ Regardless, investors rarely hire managers with a history of poor relative performance, so the manager selection merry-go-round often becomes:

1. Hire managers who have outperformed in the past.
2. Fire managers who underperform in the future.
3. Repeat.

This activity meets Einstein's definition of insanity, as many investors do the same thing over and over again while expecting different results. There are many reasons why this is an exercise in futility:

• It generally takes a long track record for a manager's alpha to be statistically significant.
• Positive alphas, even statistically significant ones, may not be an indication of skill.
• By the time you are confident there is skill, it's probably too late to benefit.
• Past performance is (really) no indication of future performance.
• If you know for sure the manager has skill, you likely won't benefit because the scarce resource captures the rent!

It Takes Time

Finding managers with positive alphas is like looking up the box scores from last night's games, but picking those who will outperform in the future is anything but trivial. To begin with, a quantitative analysis of past performance should incorporate tests of statistical significance to determine the likelihood their true alpha is not zero. In most cases, a long track record is required for the manager's alpha to be statistically significant. Given the average alpha and the standard deviation of the alpha, we can determine the track record required (in years) to obtain a t-stat of 2.

Table 1. Minimum track record for a statistically significant alpha (t-stat > 2)

		Average Alpha
		1%	2%	3%	4%
Standard Deviation of Alpha	4%	64	16	7	4
	6%	144	36	16	9
	8%	256	64	28	16

A track record of outperforming a benchmark or asset pricing model by an average of 2% per year (net of fees) over the life of the fund would get the attention of many investors, especially when you consider that the equity premium might only be around 5%. A representative standard deviation of alpha in the Morningstar universe of actively managed US equity mutual funds is approximately 6%.² As illustrated in the table above, a 2% average alpha and a 6% standard deviation of the alpha requires a track record of thirty-six years before you can be 95% sure that the true alpha is not in fact zero (i.e., there was no skill at all). Based on these parameters, by the time you are reasonably confident there is some amount of skill, the manager is likely retired and on her yacht!

The Effects of Chance

Identifying a skillful manager involves more than simply narrowing down the universe to funds with positive alphas and a t-stat of 2 or more. This approach ignores the effects of chance. There is still a 2.5% probability the outperformance was due to good luck, and the true alpha of the manager is zero. Said another way, one out of forty managers is expected to have a positive alpha with a t-stat of 2 by chance. With so many funds in the universe, many will have statistically significant alphas even when there is no skill at all.

For example, in a 5,000-fund universe, 125 managers are expected to have a positive alpha with a t-stat greater than 2, even if their true alpha is zero. Unfortunately for investors, the opportunity is not in sorting through the many managers with statistically significant alphas, but rather in finding these managers because there are too few of them. Fama and French recently studied 3,156 US equity funds and compared their performance to a simulated universe of funds in which the true alpha for every fund was zero. Their results identified fewer funds with statistically significant alphas than you would expect to find by chance.³

By Then, It's Too Late

An investor concluding that a statistically significant alpha is evidence of skill could be guilty of data mining, meaning he is making inferences from what might have been a chance outcome limited to that time period. To counter these claims, academics conduct out-of-sample tests to confirm a statistically significant result. For example, out-of-sample data can be obtained by repeating the experiment using an independent time period (e.g., 1926–1962 rather than 1963–1992) or a different data set from an overlapping time period (e.g., international rather than US market data).

Practitioners should also conduct out-of-sample tests when analyzing manager performance to help rule out that a statistically significant alpha didn't occur by chance. On the surface, conducting out-of-sample tests might seem like an overly cautious approach akin to wearing a belt and suspenders. However, even if this were true, when you consider the consequences and what is at stake, it sure beats getting caught with your pants down.

The only way to test out-of-sample data when doing performance analysis is by using totally independent time periods. Accordingly, the number of years required in Table 1 gets multiplied by the number of independent periods you're comfortable with before you have faith there is some amount of robust and repeatable skill.

Table 2. Minimum track record for two independent periods with statistically significant alpha (t-stat > 2)*

		Average Alpha
		1%	2%	3%	4%
Standard Deviation of Alpha	4%	128	32	14	8
	6%	288	72	32	18
	8%	512	128	56	32

* Assumes the average alpha and standard deviation is the same in both time periods.

Using the prior example of a 2% average alpha and a 6% standard deviation of the alpha means you need a track record of seventy-two years if you're satisfied with a statistically significant result from only two independent time periods. But, in this instance, by the time you think there is evidence of skill, it's too late—the manager may be dead!

Persistence

Having said that, let's assume you've found a manager with statistically significant alpha in multiple independent periods and she is not yet retired or deceased. The question still remains: will the positive alpha continue? You cannot rule out luck because of the effects of chance noted above, but more important, many performance studies conclude that winners do not continue to win, and even when there is alpha in the extremes, it does not persist. The only slight indication of persistence is among the extreme losers, and it is mostly explained by high fees and high turnover.⁴

If we eliminate these funds from consideration, manager selection becomes a random draw, but whether investors know they are picking them at random is another question. Their goal is often to achieve top quartile performance, and pursuit of this goal usually boils down to choosing from managers among the top quartile in the past. However, excluding the persistent losers noted above, yesterday's top quartile performers have the same 25% probability of being in tomorrow's top quartile as every other manager!

Scarce Resources

Ironically, the predicament is not only for the investor trying to identify skill but for managers trying to prove they have it. A fundamental of economics is that the scarce resource captures the rent. If capital is freely floating and perfectly liquid, then the scarce resource is not the investor's money but the manager's skill! There is an enormous economic incentive for managers to indisputably prove they are in possession of this elusive ability.

Let's assume a manager has a twenty-year track record of outperforming by 4% each year. In this extreme example, a t-stat is meaningless since the standard deviation of the alpha is zero. If we rule out the possibility of a Ponzi scheme, the manager surely has undeniable skill. However, as soon as she proves her unique ability, she can capture the rent by increasing her fees to nearly 4%. An increase in fees of this magnitude may draw the ire of her investors, so, alternatively, she could raise more and more assets, thereby distributing her alpha over a larger asset base, which would dilute investor results.⁵ This latter approach may largely go unnoticed by investors, but either way they lose as their alpha subsequently becomes zero.

Making Progress

So, herein lies the paradox of skill. Many investors are searching for the Holy Grail of fund management. Their goal is to identify a skillful manager with certainty and participate in future returns. But confirming skill takes an investment lifetime, and you can never be fully confident that the alpha is not random. Even if you could identify skill ahead of time, you probably would not benefit. Winning managers hike their fees or attract large volumes of new investment long before their skill is statistically confirmed—and both actions can dilute returns.

But this paradox is not a case of "damned if you do and damned if you don't" for all investors. You can get off the manager selection merry-go-round and start making progress toward a successful investment experience by following these simple principles:

1. Diversify by asset class rather than by fund manager, broker, or advisor.
2. Buy into markets, not managers, and let capitalism be your guru.
3. Focus on what you can control—costs, asset allocation, risks, and discipline. Ignore what you cannot control—the media, prognosticators, market returns, and your gut.
4. Work with an advisor who understands these principles and can help you apply them.

The comments of Weston Wellington are gratefully acknowledged.

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1. Noteworthy studies include: Mark Carhardt, "On Persistence in Mutual Fund Performance," Journal of Finance 52, no. 1( March 1997). Garrett Quigley and Rex A. Sinquefield, "Performance of UK Equity Unit Trusts," Journal of Asset Management 1, 72-92. James L. Davis, "Mutual Fund Performance and Manager Style," Financial Analysts Journal 57, no. 1 (Jan/Feb 2001).

2. Source: Index Funds Advisors.

3. Eugene F. Fama and Kenneth R. French, "Luck Versus Skill in the Cross Section of Mutual Fund Returns," Journal of Finance 65, no. 5 (October 2010): 1965–1947.

4. Carhardt, "On Persistence in Mutual Fund Performance." Fama and French, "Luck Versus Skill in the Cross Section of Mutual Fund Returns."

5. Jonathan Berk and Richard C. Green, "Mutual Fund Flows and Performance in Rational Markets," NBER Working Paper No. W9275, October 2002.

Don't Worry Over Largest Ever Muni Bond Default

By Larry Swedroe

(MoneyWatch)

Alabama's most populous county declared bankruptcy in hopes of addressing a massive revenue shortfall and its whopping $4.15 billion in debt. Jefferson County's Chapter 9 filing is the largest municipal bankruptcy in U.S. history.

This formal declaration doesn't necessarily mean investors will lose their money. Consider the 1994 case of Orange County, Calif., which was the largest municipal bankruptcy on record prior to Jefferson County, with debts totaling $1.7 billion. In the end, all debts were fully repaid.

Jefferson County's declaration provides us with a good opportunity to review the overall state of the municipal bond market. Last December, Meredith Whitney caused quite a stir when she predicted on CBS' "60 Minutes" "between 50 and 100 'significant' municipal bond defaults in 2011, totaling 'hundreds of billions' of dollars." Her forecast helped trigger investors to withdraw money from municipal bond funds for 24 consecutive weeks. Unfortunately for Whitney and those investors who gave credence to her forecasts, it would be hard for her to have been more off the mark.

Meredith Whitney on 60 Minutes

The massive scale of problems that Whitney anticipated hasn't appeared because governments have taken actions to address the problem -- cutting spending and raising revenues. Unlike the federal government, states are required to balance their budgets. As a result, budget gaps are being closed by layoffs of public employees, greatly reduced services, renegotiation of contracts with union members on wages and especially benefits, and increased taxes and fees. These actions have gotten results. For example:

-- Preliminary data from the Rockefeller Institute reported that state revenues from July and August were 6.8 percent higher than the same period in 2010.

--Standard and Poor's said municipal bond defaults were down 69.0 percent from January through October, versus the same period in 2010.

--Prior to Jefferson county's declaration, outstanding defaulted issues totaled just $6.6 billion.

It's also important to point out that of the now 200 outstanding defaulted issues, 8.0 percent were issued for multifamily residential projects, 10.5 percent for health care, and 43.7 percent for land-backed deals. These are sectors of the municipal bond market I recommend you don't even consider (regardless of the credit rating) because of their relatively poor historical default records.

While the year isn't quite over, the roughly $11 billion in defaults is a long way from hundreds of billions. Keep these results in mind the next time you're tempted to react to some dire forecast. And remember that the academic research on the ability to forecast the future demonstrates that it's not possible. The only good predictor is fame -- the more famous the forecaster, the more likely he or she is to be wrong.

http://www.cbsnews.com/8301-505123_162-57322367/dont-worry-over-largest-ever-muni-bond-default/?tag=mncol;lst;3

October Fest

By Jim Parker

Ever noticed how gamblers always tell you about their big wins, but tend to keep their even bigger losses close to their chests? People who seek to finesse their entry and exit of financial markets are similar.

Going awfully quiet in recent days have been the analysts who a month ago were saying that that was the time to get out of risk assets. It seemed a good call at the time as global stock markets had suffered their worst quarter in nearly three years.

Pummelling confidence were a host of concerns, including the European sovereign debt crisis, signs that global growth was stalling and a general lack of confidence in policymakers to take effective action to avoid another recession.

One chartist quoted by Dow Jones¹ said the US market was breaking down in what could be a very nasty prelude to the fourth quarter. The advice from the technical analysts was that investors needed to be extremely wary buying stocks in October.

Adding to the nerves were the now routine reminders² to investors about October supposedly being the "scariest" month for shares, with two of the biggest crashes in history occurring in the 10th month of the year–in 1929 and 1987.

Now while further volatility may well still lay ahead, those who took that advice and bailed out of risky assets at the end of September might now be ruing their decision.

The US S&P-500 rose by nearly 11 per cent in October, its largest monthly rise since 1991.³ That was the year that dance act 'C&C Music Factory' was topping the pop charts and 'The Silence of the Lambs' won Best Picture at the Academy Awards.

But it wasn't just a US story. The MSCI All-Country World Index rose by 10 per cent in October in US dollar terms, its largest one-month rally since April, 2009. In Australia, the S&P/ASX-200 gained 7.2 per cent in local currency terms, its best one-month performance since July, 2009. What's more, among the biggest gaining sectors in October were financials, energy and materials sectors, which had all lagged in the defensive mood of the prior months.

These are significant upward movements and will have eased some pain for investors after five-to-six months of consecutive decline in equity markets, but not if you had listened to the advice of some of the Jeremiahs in the financial media.

It's not often appreciated by ordinary investors that markets are forward looking. We know the news has been bad, but it's what comes next that counts. Selling out after a bad run in the markets just means you turn paper losses into real ones and leave yourself with the extremely difficult challenge of finessing your re-entry point. The reversal of direction in October highlights this difficulty.

We don't know if these October gains are sustainable — and already in November, sentiment around Europe has turned sour again. But we do know that markets can move quickly and respond to new information instantaneously. That's why market timing is so hard and why the best approach is to maintain your chosen asset allocation–with periodic rebalancing–irrespective of the week-to-week and month-to-month noise.

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1.'MARKET TALK: Use Extreme Caution Buying Stocks' — Dow Jones Newswires, Sept 24, 2011

2.'Share Jitters Deny US Rise', Daily Telegraph, Sydney, Sept 26, 2011

3.'US Stocks Decline Amid Concern About European Funding', Bloomberg, Oct 31, 2011

Increased Market Volatility: Fact or Fiction?

By Larry Swedroe

The financial media has been filled with headlines about market volatility. From one perspective, this may make sense, as the previous quarter saw 19 trading days experience market moves of more than 2 percent, compared with just one such day the previous quarter.

Based on my conversations with both investors and advisors alike, the perception is that markets have certainly become more volatile. The question is: “Does the historical evidence match up as well?” To find the answer, we go to our trusty videotape.

For the period 1927-1999, the annual standard deviation (measure of volatility) of the S&P 500 Index was 20.3 percent. From 2000 through 2010, the annual standard deviation was a virtually identical 20.5 percent.

Perhaps if we look at the data on a quarterly basis, we’ll find more volatility. The quarterly standard deviation of the S&P 500 prior to 2000 was 11.7 percent. Since then, it has been 9.0 percent — volatility prior to 2000 was 30 percent higher.

So let’s try looking at the data on a monthly basis. Prior to 2000, the monthly standard deviation was 5.7 percent. Since then it has been just 4.7 percent — volatility prior to 2000 was more than 20 percent higher.

Small-Cap Stocks
Since we can’t find the explanation in the large-cap stocks of the S&P 500, perhaps we can find it in small-cap stocks. From 1926 through 1999, the annual standard deviation of the CRSP 6-10 Index (which represents small-cap stocks) was 31.2 percent. For the period 2000 through 2010, the annual standard deviation was 28.7 percent. The annual volatility of small caps was 9 percent more prior to 2000 than it was after. On a quarterly basis, the standard deviation was 19.7 percent prior to 2000 and just 12.9 percent from 2000 through June 2011. Prior to 2000, the quarterly volatility was 53 percent higher. On monthly basis the standard deviation prior to 2000 was 8.1 percent. Since then it was 6.7 percent. Prior to 2000 the monthly volatility was more than 20 higher than it has been since.

International Markets
Perhaps if we look at the volatility of international markets, we’ll find the explanation for the perception that the equity markets have been more volatile. From 1970-99, the annual standard deviation of the MSCI EAFE Index was 20.6 percent. From 2000 through 2010, the annualized standard deviation has been a virtually identical 20.7 percent. So that probably isn’t the source of the perception either, though we note that the monthly and quarterly volatility of the MSCI EAFE was 8 percent and 17 percent higher, respectively, since 2000.

Emerging Markets
Stretching the case, we can also look at emerging markets. Here we do find a relatively small increase in volatility, not the much greater increase the media and the “experts” have portrayed. On annual basis, the standard deviation of returns was 36.7 percent from 1988 through 1999, and 38.3 percent from 2000 through 2010, an increase of just 4 percent. On quarterly basis (through September 2011), the standard deviation increased from 13.6 percent to 14.1 percent, an increase of 4 percent. On monthly basis, the standard deviation increased from 6.9 percent to 7.1 percent, an increase of just 3 percent. These small increases almost assuredly wouldn’t have been noticed by most investors, and thus can’t explain why there’s this perception of greatly increased volatility.

Since I don’t have access to the daily data, I can’t rule the possibility that the perception of higher volatility is caused by the markets being more volatile on a daily basis. But investing for the long run while paying attention to the market’s daily noise is (as Alan Abelson noted) like a man walking up a big hill with a yo-yo and keeping his eyes fixed on the yo-yo instead of the hill. The bottom line is that the media needs to create noise to get you to pay attention, even if paying attention is bad for both your stomach and your investment results.

Photo courtesy of Katrina.Tuliao on Flickr.

Read more: http://moneywatch.bnet.com/investing/blog/wise-investing/increased-market-volatility-fact-or-fiction/3108/#ixzz1ceuiXaC0

What's in Your View Finder?

By Weston Wellington

He is no longer with us, and the world is poorer for it.

A restless college dropout, he founded a wildly successful company whose innovative products touched millions of lives. He was a brilliant, dictatorial, and cantankerous leader, relentlessly pushing his staff to solve one impossible problem after another. He had no use for conventional market research, and trusted his own vision to create products with little detectable demand that flew off the shelves upon introduction. He zealously guarded his personal privacy but reveled in his role as a master magician on stage when introducing his firm's latest innovations to eager crowds of industry followers. Stockholders wore big smiles as the shares vaulted to one new high after another. In many ways, he was the antithesis of the conventional corporate chieftain, and despite his demanding persona, he was revered by employees, customers, and even competitors to a greater extent than almost any other chief executive in recent memory.

A tribute to the late Steve Jobs? No—to Edwin Land of Polaroid.

The son of a scrap metal dealer, Land dropped out of Harvard to pursue his own research at the New York Public Library on polarized light filters. He founded Land-Wheelwright Laboratories in 1934 with his former physics professor, and his low-cost polarizing filters proved useful in products ranging from sunglasses to army tank telescopes and gunsights. After the war, he turned his attention to photography and introduced the Polaroid-Land instant camera in 1948. Despite a stiff price tag of $89.75 the first shipment of 57 cameras sold out in a matter of hours at a Boston department store, and the firm never looked back.

Numerous improvements followed, and sales boomed as the cameras and film became smaller, lighter, easier to use, and less expensive. The stock price did likewise, and Polaroid became a bellwether "glamour" stock during the postwar bull market, soaring tenfold in just five years from 1963 to 1967.

When a cover story in Time appeared in June 1972, Polaroid seemed all but unstoppable. Land's inventive genius had resulted in an astonishing new industry with technology protected by a wall of over 1,000 patents. (Land himself held 535 patents, second only to Thomas Edison.) Eastman Kodak offered only token competition in instant photography, and was eventually vanquished in both the marketplace and the courtroom. Kodak was forced to pay Polaroid nearly $1 billion to settle a patent infringement suit and withdrew from the instant camera business. Polaroid shares reached an all-time high of $149.50 in mid-1972, amid intense excitement over the ingenious new SX-70 single lens reflex color camera and rumors of an instant movie product. Government surveys at the time identified photography as one of the fastest-growing industries in the country, and Polaroid appeared to be a key beneficiary: In the premium category (cameras selling for $50 or more), Polaroid was not only the undisputed leader but outsold all other global competitors combined.

Land was one of Steve Jobs' heroes, and the youthful computer tinkerer from California felt almost a mystical connection with the Cambridge scientist forty-six years his senior. Both were impatient perfectionists, often driving themselves even harder than their overworked employees. Land was infamous for wearing out staff members, who rotated in shifts while he focused on knotty problems. During one marathon research session, Land wore the same clothes for eighteen straight days. When Jobs had the opportunity to meet Land personally, he found that he and Land shared a peculiar characteristic: Both believed that new products were not invented so much as discovered. Both could visualize a product that did not yet exist down to its smallest details, and the task of development was thus akin to Michelangelo's description of sculpture: The artist's task was to remove the unnecessary material to reveal the beauty already contained within the stone.

Alas, Time's cover story marked the beginning of the end. The instant movie project ("Polavision") turned out to be a costly failure and led to Land's resignation in 1980. Jobs was dismayed when Land was pressured to leave the firm he had founded, calling him a "national treasure." Jobs would suffer a similar fate after a losing boardroom battle in 1985.

Although Polaroid products continued to sell well, the shift to digital photography caught the firm unprepared and slowly hollowed out the highly profitable film business. Polaroid filed for bankruptcy in October 2001. The research labs and film factories were shuttered, although the brand name, traded from one sharp-elbowed financier to another, survives as a ghostly reminder of its illustrious past. The years have been kinder to Eastman Kodak, but not by much. Founded long before Polaroid in 1888, it has outlived its former adversary but now struggles to avoid a similar fate.

What is the message for investors?

As we observed in a previous note, the forces of competition are relentless, and today's astonishing innovation may be tomorrow's commodity—or garage sale castoff. We have no reason to believe that Apple has anything but a bright future, but those of us tempted to concentrate our investment capital in a handful of exciting industry leaders should consider the fate of Polaroid before declaring, "It can't happen here."

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Securities Research Company, SRC Green Book, 1993 edition.

"Polaroid's Big Gamble on Small Cameras," Time, June 26, 1972.

"The Story of Polaroid Inventor Edwin Land, One of Steve Jobs' Biggest Heroes," 37signals www.37signals.com, accessed October 14, 2011.

The Accuracy of Experts' Forecasts

By Larry Swedroe

There’s an overwhelming body of evidence on the inability of forecasters to make accurate predictions. This inability is one reason why efforts to outperform the market without taking more risk have failed with such persistence. This is true for both the stock and bond markets. The following is a recent example that while it might be easy to make a living selling forecasts, it’s very difficult for even the experts to make accurate forecasts.

A year ago, the Reuters news agency polled 16 money market dealers who do business directly with the Federal Reserve. These “primary dealers” — banks or broker-dealers — are market makers for government securities. They even consult directly with the US central bank and Treasury about funding the budget deficit and implementing monetary policy.

One might hypothesize that if anyone could get the forecast right it would be them. Reuters asked the dealers for their forecasts for Treasury bond yields three, six and 12 months ahead. Their consensus forecast was for 10-year Treasury note yields to rise from 2.5 percent to 3.2 percent by September 2011. Investors paying attention would shorten maturity risk. Today, we know that they were not only off by about 1.5 percent (the 10-year note now yields about 1.75 percent), but more importantly from a strategy standpoint, they got the direction wrong. Investors who paid attention not only failed to earn the term premium that existed at the time, and missed out on the large capital gains that the fall in rates produced, but now they’re faced with reinvesting at much lower interest rates.

But they weren’t the only ones that got it dead wrong. In February 2011, the bond “king” Bill Gross announced that the world’s biggest bond fund had reduced its US government-related debt holdings from 22 percent in December 2010 to just 12 percent in January 2011, the lowest in two years. In March, PIMCO announced it had eliminated government related debt entirely from its flagship fund, saying that bond yields had reached unsustainably low levels given the scale of government debt obligations and the chance of a correction when the Fed ended its quantitative easing program.

By August, Gross admitted he had made a big mistake, and he reversed course.

The aforementioned failures of the so-called experts to get forecasts right is nothing new. William Sherden, author of The Fortune Sellers, was inspired by the following incident to write his book. In 1985, when preparing testimony as an expert witness, he analyzed the track records of inflation projections by different forecasting methods. He then compared those forecasts to what is called the “naive” forecast — simply projecting today’s inflation rate into the future. He was surprised to learn that the simple naive forecast proved to be the most accurate, beating the forecasts of the most prestigious economic forecasting firms equipped with PhDs from leading universities and thousand-equation computer models.

Sherden reviewed the leading research on forecasting accuracy from 1979 to 1995 and covering forecasts made from 1970 to 1995. He concluded that:

• Economists cannot predict the turning points in the economy. He found that of the 48 predictions made by economists, 46 missed the turning points.
• Economists’ forecasting skill is about as good as guessing. Even the economists who directly or indirectly run the economy (such as the Fed, the Council of Economic Advisors and the Congressional Budget Office) had forecasting records that were worse than pure chance.
• There are no economic forecasters who consistently lead the pack in forecasting accuracy.
• There are no economic ideologies that produce superior forecasts.
• Increased sophistication provided no improvement in forecasting accuracy.
• Consensus forecasts don’t improve accuracy.
• Forecasts may be affected by psychological bias. Some economists are perpetually optimistic and others perpetually pessimistic.

Economist and Nobel Laureate Paul Samuelson observed: “I don’t believe we’re converging on ever-improving forecasting accuracy. It’s almost as if there is a Heisenberg [uncertainty] Principle.” Michael Evans, founder of Chase Econometrics (now IHS Global Insights), confessed: “The problem with macro [economic] forecasting is that no one can do it.”

The bad news is that no matter how much we want to believe in fortune tellers, the problem is that they all have cloudy crystal balls. One reason for the inability of even the experts to see through those clouds is that markets have a nasty tendency to provide surprises, which by definition are not forecastable. The result is that the efforts to try and manage returns are highly likely to prove unproductive. Instead, you should focus on the things you actually can control, the types and amount of risk you take, diversifying those risks prudently, costs and tax efficiency.

And finally, remember that since the underlying basis of most stock market forecasts is an economic forecast, the evidence suggests that stock market strategists who predict bull and bear markets will have no greater success than do the economists.

Read more: http://moneywatch.bnet.com/investing/blog/wise-investing/the-accuracy-of-experts-forecasts/3020/#ixzz1ZqOJqXI9