9
October
2009
This article first appeared in the Sunday Tribune on 11th October 2009.
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We are often asked by clients to make some sort of a prediction about the future price of stocks, property or other assets. However, this approach – essentially attempting to guess the future – is fundamentally flawed.
Advisers, wealth managers and stockbrokers should not be paid for trying to predict the future, since the future is uncertain and random events can alter markets in unpredictable ways. The antidote to this uncertainty is diversification not crystal ball gazing.
To illustrate the enormous difficulty of the task of attempting to guess the best place to invest next year, simply ask yourself this: what was the best place to invest your money last year? It’s difficult isn’t it? You would probably need to look it up.
One of the best places to invest in 2008 was Long Term Government Bonds, up 17.51% in 2008, but they were one of the worst places to invest in 2006 and 2007 down 8.73% and 6.67% respectively. Attempting to move in and out of different investments, or market timing, is fraught with difficulty. You need to be correct in your decisions more than once, when to get in, when to get out and when to get back in again. In a study in the US of 15,000 predictions over a 12 year period from 237 Market Newsletters, there was no evidence of any skill in the predictions made. Examples of predictions that were correct are just as likely to be lucky as skilfull and distinguishing luck from skill is extremely difficult over short time periods.
Attempting to identify investment managers with stock picking skill is slightly easier – there don’t appear to be many. In a study of 2,100 stock pickers over 32 years, 99.4% of fund managers were shown not to have verifiable stock picking skill. Those managers who beat the market were fewer than the proverbial large group of monkeys with a dart and a stock sheet. Why do we see so few skilled fund managers beating the market? One reason may be that the monkeys work for bananas.
Finally, in a study of 660 hiring and firing decisions made by investment consultants selecting investment fund managers, the fired managers beat the hired managers who replaced them.
A better approach to the conventional wisdom that is typically sold around the world is to consider the role of any investment within a wider, diversified portfolio in relation to how one might expect it to perform, on average, based on a detailed understanding of how it has performed in the past.
Now, we have to be careful to be clear on one thing here. We are not suggesting that an investor looks at the last 2 or 3 years and attempts to draw any meaningful inferences. For example, if we look at the performance of the stock market as measured by the MSCI World Index over say the last 3 years the average annual return was about -7.32%pa. One might conclude, based on this time period, that an investment in the stock market is a bad investment. However, it takes about 30 or 40 years of data to prove statistically that stocks outperform cash over the long run.
Over the period Jan 1971 to end September 2009 in US$ the average annual return from holding Gold has been 8.70%pa compared to 5.71%pa for cash as measured by one month Treasury Bills. The stock market as measured by the S&P 500 returned an average annual return of 9.92%pa. Over the long term, Gold has done a good job of preserving wealth.
So, when considering if one should buy gold at around $1050 per ounce, if one is buying gold for the reason of financial insurance or as a hedge against risk, then the price paid today is not so relevant to the decision to purchase. By the same reason that I don’t cancel my house insurance just because my premium has increased since last year. I don’t buy house insurance because I hope my house catches fire I buy house insurance in case it does.
Gold is a form of financial insurance within a portfolio. It is a refuge from risk and should therefore be used within a portfolio to reduce exposure to other forms of systemic or market-wide risk, such as banks failing that affect markets from time to time. However, because bad news events like September 11th 2001 are so random in nature, the smart way to think about any investment decision is not to think about the price paid today, since the current price reflects all of the opinions of all of the buyers and sellers around the world. Investors should not be trying to out-guess the market but rather acknowledge that the news will continue to break in the future in random ways which will move future prices of all investments in random and unpredictable ways. Diversification is the antidote to uncertainty.
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