Eventually, the thinking goes, your current manager will have a poor year, or a poor twenty years, and you will inevitably start thinking about moving your hard-earned capital to another, more prospective wealth management group. If their firm has caught your attention over the years more often than other firms, the thinking goes, you are more likely to seek them out than their competition.
Actual results to mutual fund investors vs. stock and bond benchmarks – 1991 to 2011
Now, here is the evidence. The following charts show aggregate forecasts from Wall Street’s most famous oracles through time, next to the actual trajectory of the forecast variable. Note that these charts are sourced from James Montier’s book Behavioural Investing (2007):
Do any experts get it right? What about the experts at the Federal Reserve who are in charge of setting interest rates? Can they predict the magnitude or direction of interest rates over the next six months?
A working paper entitled “History of the Forecasters: An Assessment of the Semi-Annual U.S. Treasury Bond Yield Forecast Survey” (Brooks & Gray, 2003) studied the ability of Federal Reserve economists, including Alan Greenspan, from 1982 – 2002 to discover whether the group of experts that sets interest rates is able to effectively forecast their trajectory through time.
Chart 3.
Source: (Brooks & Gray, 2003)
Again we see a strong talent for describing what has just happened, but no talent whatsoever for predicting what will happen next. Just how poor was the forecasting ability of Fed economists, including sitting Fed Chairmen like Alan Greenspan, over the 20 year survey?
Chart 4.
Source: (Brooks & Gray, 2003)
The scatter plot above shows how Fed forecasts of interest rates six months out are negatively correlated with actual outcomes. The r-squared of the regression is 0.07, which is not statistically significant, but if you were a betting man, your best bet would be in the opposite direction of what is forecast to happen by the people who actually set interest rates for the economy.
The quantum leap in thinking that we strive to compel with this post is toward an understanding that the world is too complex to enable accurate forecasting. Axiomatically, people should consider expert forecasts as no more than entertaining narratives – brain candy to stimulate the imagination.
The best we can hope for is an assessment that an existing dynamic or trend is likely to stay on a certain course, or alternatively that the dynamic is reverting to the mean. Forecasting the direction or the magnitude of the change in trend is empirically impossible.
Fortunately, statistics offers a useful toolkit for evaluating the probability of trend continuation or mean reversion, and offers an estimate about the magnitude of the change. Further, statistical models tell us how confident we should be in our estimates given the amount of data we have at our disposal, and the type of problem we are trying to solve.
Quantitative systematic approaches to investing explicitly leverage the power of statistics to make a large number of bets with better than even odds of success. Quantitative risk management techniques and optimizations can further stabilize results by minimizing the impact of being wrong, which in markets will happen a lot.
Quantitative approaches are no silver bullet – they suffer periods of poor performance too. But they are explicitly built to take advantage of the law of large numbers, and to stay out of trouble when statistical forecast accuracy is poor.
For more information about quantitative approaches, please read the following articles.