I have firmly believed for a long time now that Wall Street has been selling the premise that skilled portfolio managers can outperform the financial markets through security selection, market timing and other efforts based on prediction. Such predictions, even if coming from smart strategists, largely are proven to be overwhelmingly inaccurate, yet many individual investors still rely on them to make their investment decisions — often to their detriment.
In my opinion, it’s time for this myth of Wall Street’s ability to accurately predict market outcomes to be put to rest.
A recent op-ed article1 presents some evidence:
- For every year from 2000-2018, the consensus prediction by Wall Street analysts for the returns of the S&P 500 one year later was always positive, even though the market declined in six of those years. The consensus was wrong about the basic direction of the market 30% of the time.
- The median forecast was that the stock index would rise 9.8% in the next calendar year. The S&P 500 actually rose an average 5.5% (as of December 31, 2018). The gap between the median forecast and the market return was 4.31 percentage points, an error of almost 45%.
Of course, if the consensus is always for positive forecasts, then the forecasts were wrong when an accurate forecast would have mattered most — the years of significant market declines. In 2008, for example, when stocks fell 38.5%, the median forecast called for an 11.1% stock market increase. Of course, by definition an analyst would never be able to forecast a truly unpredictable event such as a global pandemic.
Another review of analysts’ buy, sell and hold ratings of all the stocks in the S&P 500 in 2018 found that not one of the 505 stocks in the index (note: there were actually 505 stocks because five of the companies in the index have two classes of common stocks) had a majority rating of sell.2 In other words, every stock was rated majority buy or hold. How is it possible that truly independent analysts would all reach the conclusion that not one company was overpriced and should be sold? It should not be overlooked that analysts are often biased. Securities laws and regulation require brokerage firms to keep a wall between their analyst department and their investment banking operations, which often generate business from these same companies the analysts are analyzing. Whether it always happens is not for us to say, but we have our skepticism and investors should too.
Two headlines on April 6, 2020, show the extremes of Wall Street predictions:
- “Investors should prepare for a … ‘vicious spiral’ more than twice as bad as the financial crisis,” says a “well-known Wall Street firm #1”.3
- “‘The worst is behind us’ — with the most attractive risk-reward in years, it is time to buy stocks,” says a “well-known Wall Street firm #2”.4
Given the inability for anyone to accurately predict the outcome of a global pandemic, or the behavior of the stock market for that matter, these types of predictions seem downright silly and even potentially damaging.
The evidence reflects that the vast majority of investment managers who try to outperform the markets generally end up underperforming the markets. Over a 15-year period ending December 31, 2019, 89.1% of active stock mutual funds (compared to passive index funds) underperformed their benchmark.5
Why do Wall Street firms continue to make bold predictions?
This raises two questions: Why do people continue to listen to Wall Street analysts? And why do Wall Street firms continue to make predictions they probably realize are likely to be inaccurate?
The first question is easy to answer. There’s a burning human desire to want concrete answers to an unknown future. We are drawn to any analysis that looks like engineering with a certain outcome and definite answers.
We want to think the future of companies and stock prices can be measured cleanly, with precision, in ways that make sense. If you think finance is like engineering, 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 December 31 of every year.
But finance isn’t a science with known data. Instead, it’s messy with lots of unknowable information about the future of hundreds of data points that could affect each company’s profits — cost of goods to make products, customer tastes, shipping costs, fuel costs, tax rates, costs of borrowing funds for operations, competitors, government policies, global events and hundreds more. There is simply no consistent, predictable way for anyone to know the future of all these hundreds of data points, no matter how much the analysts may be trying to be as accurate as possible.
Yet the financial industry continues to issue prediction after prediction. Why? It’s a huge business. Active money managers who are trying to beat the markets (as opposed to passive money managers who simply own the entire market) received $600 billion in fees in 2014.6 There is a huge financial incentive to continue to perpetuate the myth of Wall Street’s ability to accurately predict the future.
We believe that a more prudent way to make investing decisions is one that doesn’t rely on such predictions. Instead, it is based on long-term historical data of expected returns of the markets over time. It also assumes that there will be significant market declines from time to time, which is more realistic than the Wall Street predictions.
As difficult as it may be, it’s time to let go of our understandable desire for predictability and certain outcomes in an uncertain world. This desire for control and predictability only serves to perpetuate these Wall Street myths. Instead, let’s embrace the uncertainty, make investment allocations that are appropriate for our risk tolerance and financial goals, and let the markets work to hopefully better outcomes.
Ready to take a realistic look at your portfolio? Reach out.