The Futility of Forecasting Market Returns: Why It’s Better to Focus on the Long-Term Plan
Market Forecasts Are a Problem
The Issue
Back in my discount brokerage days when I was licensed for US investors, I once spoke to a person who held only cash in what was left of his investment portfolio. He had sold his stock holdings shortly after Barack Obama won his first election in November 2008, convinced that no good could come from the election of a Democratic president.
This is not the beginning of a blog on the role presidential elections play in the stock market. Rather, it is an example of people predicting stock market returns based on one factor or another.
Of course, there are many people out there, notably economists and financial analysts, who write columns or appear on business-oriented talk shows and are looked to for predictions about where the markets are headed. You will hear recommendations to “overweight” this sector, “underweight” that sector, sell stocks altogether and buy government bonds, or maybe even “go to cash.”
The Appeal of Market Forecasting
Predictions are appealing to investors. It provides a (wholly illusory) sense of control over one’s future. Acting on these forecasts responds to our deeply rooted need to “do something” (“Don’t just stand there; do something!”). It gives us hope that we can “beat the market” or protect ourselves from a predicted downturn.
The Core Problem
While it’s tempting to follow these forecasts, the truth is that these predictions rarely work out, leading investors to make costly, unnecessary changes to their portfolios.
History Reveals the Futility of Forecasting
Examples of failed predictions
History is littered with market forecasts that went wrong.
- In the mid-1980s, a professor of economics at Southern Methodist University, Ravi Batra, wrote a bestseller, entitled The Great Depression of 1990. However, aside from the year 1990 itself, which had a relatively minor negative return, the 1990s were a period of excellent returns for the US markets, with the S&P 500 index averaging 21% over the decade 1990 -1999. The Canadian market, as represented by the TSX, was much more volatile than the US market, but even it managed an average return over the decade of 10.5%.*
- During 2014, oil prices were cut in half (from over $100 per barrel to less than $50). Many analysts predicted that the Canadian economy would suffer because we rely so heavily on the oil and gas sector. However, the TSX composite went up 10.6% that year.
- In 2010, Peter Schiff predicted that the Quantitative Easing (QE) program undertaken by the US Federal Reserve as well as many other central banks in the wake of the Great Financial Crisis (GFC) would lead to hyperinflation.
Risk of Emotional Investing
Forecasting in the financial markets can strongly influence how investors behave. When predictions show drops or crashes, fearful investors might sell their investments quickly, which can lead to losses instead of waiting for the market to get better. On the other hand, positive forecasts can cause investors to buy based on greed without anchoring their investment decisions on proper research. This behaviour can create bubbles that later burst, causing big financial problems. Relying too much on forecasts can make investors act based on emotions rather than thinking carefully about long-term plans.
The Short-Term Nature of Forecasts
Forecasts typically look at what might happen in the markets over a short period. However, short-term movements are hard to predict because the market can change quickly and be influenced by many different things. Small events or news can cause prices to go up or down in ways that are exceedingly difficult to anticipate. This is often referred to as “noise” that needs to be filtered out. Because of this, short-term forecasts are often wrong and can mislead investors. It is usually better to focus on long-term trends, which are easier to understand and predict.
As an example, here is a chart of the change in monthly returns of the hypothetical couple I have used before in my blog, Ross and Emily. The horizontal numbers in the middle of the chart represent the months. With 145 numbers, there are over 12 years of monthly data. Despite their modest 55% equity allocation, there are still a lot of gyrations month to month, including dramatic declines and gains of over $100,000. That’s “noise.” To some, it may even look like the static noise from a radio signal that is not tuned to a radio station.
Behavioural Finance Insights
Behavioural finance studies show that people naturally follow forecasts due to certain habits. Herding behaviour means they copy what others do, so they follow forecasts because everyone else is. Confirmation bias leads them to look for information that supports what they already believe, making them trust forecasts that match their views, even if the data says not to. The recency effect makes people give more importance to recent information, thinking current trends will continue. These very human and normal habits tend to cause people to act irrationally about the markets, often ignoring solid data for persuasive forecasts.
Focus on a Long-Term Strategy
The case for a long-term, steady strategy
A long-term investment plan that matches your financial goals, risk tolerance, and time horizon offers a more stable way to grow your wealth. Instead of reacting to short-term market forecasts, which can cause emotional and often poor choices, a steady plan focuses on patience and consistency. By investing with a long-term view, you can better handle market ups and downs and benefit from the power of compounding returns. This leads to more predictable and lasting financial growth.
Long-Term Returns Are More Predictable
Historical data shows that, over the long run, the markets tend to provide solid returns, even though there may be short-term volatility. While the markets may experience significant ups and downs due to various factors like economic events, news, and investor sentiment, these fluctuations usually even out over time. Investing with a long-term perspective allows investors to ride out these short-term swings and benefit from the market’s overall growth. This steady approach reduces the impact of temporary market noise and focusses on the more predictable upward trend of long-term returns.
As an example, below is a chart of the monthly returns over 20 years of the S&P/TSX Composite Index (green) and the S&P 500 Index (purple). Monthly returns over a couple of decades look a lot smoother, even though you can clearly see the bottoming out of the GFC in early 2009, the impact of COVID-19 in early 2020, and the impact of inflation in 2022.
Source: TD Webbroker 2024-12-02
Diversification as a strategy
Diversified portfolios can handle unpredictable market changes, reducing the risks of trying to time markets or focusing on only one sector or country because it is expected to do well. Once again, note the chart above. In the first 10 years, the S&P/TSX did better, while the S&P 500 did much better in the last 10 years. This difference in performance at different times shows why it’s important to diversify. Different markets perform better or worse at different times. For example, Canadians should consider investing outside their country (and not just in the United States!) to access growth opportunities and lower risk. The chart is a visual example of why having a diverse investment strategy is useful in dealing with different market conditions over time.
The importance of an Investment Policy Statement (IPS)
Having a clear Investment Policy Statement (IPS) helps investors stay on track by providing a structured plan that fits their long-term financial goals, risk tolerance, and time horizon. It acts as a guide during market volatility, preventing reckless decisions based on short-term trends. Maintaining a systematic investment process, even during market downturns, is important. This method encourages investors to keep investing regularly, no matter the short-term market changes. Also, the idea that “time in the market” is better than “timing the market” highlights the benefits of staying invested for the long term. By sticking to an IPS, investors can focus on the bigger picture, making steady progress toward their financial goals despite the inevitable fluctuation of their investments.
Practical Advice
Practical advice for investors
Suggest steps for investors to take to avoid the trap of forecasting:
- Stick to a well-diversified portfolio that matches your long-term goals. This means spreading your investments across different types of assets, sectors, and regions to reduce risk and increase potential returns over time, making sure your investments grow steadily and securely.
- Set up automatic contributions to your investment accounts. This reinforces consistent investment behaviour, regardless of market conditions, and reduces the temptation to follow the latest forecast.
- Focus on maintaining an appropriate risk profile, adjusted for life changes, not market whims. This means making sure your investments still match your changing needs, like income, family duties, or retirement plans, instead of reacting to short-term market movements.
Regularly review, but don’t constantly adjust investments based on short-term forecasts. This means checking your portfolio regularly to ensure it matches your goals, but avoiding the urge to make frequent changes based on temporary market conditions or predictions.
The Benefits of Financial Planning
Working with a financial planner can help you stay on course by providing guidance that focusses on your long-term goals, rather than the latest market forecast. I also want to note that, while an Investment Policy Statement (IPS) or investment plan is crucial, it is not a comprehensive financial plan. A full financial plan should also address key areas like financial management, tax planning, retirement planning, your need to offset risks with insurance or other methods, and estate planning. By covering all these aspects, a financial planner ensures that your overall financial health is managed effectively, securing your future regardless of market changes or forecasts.
You Have the Tools to Succeed Without Relying on Forecasts
You Can Succeed at Investing
You don’t need to constantly predict market returns to invest successfully. Focus on a well-thought-out, long-term plan and stick to it, knowing that patience and consistency are the keys to building wealth over time.
Focus On the Bigger Picture
Keep your eyes on the bigger picture and trust that steady, long-term planning is your path to reaching your financial goals. By staying committed to your plan and being patient, you will successfully navigate short-term uncertainty in the markets and build lasting wealth over time.
Your Call to Investment Action
Consider whether your current portfolio strategy aligns with your financial goals and needs any adjustments. For personalized financial planning advice tailored to your situation, don’t hesitate to reach out to a qualified professional. They can help you create a comprehensive plan that addresses all aspects of your financial health and keeps you on track to reach your goals.
*Annual returns for the S&P 500 and the TSX were based on the Periodic Table of Annual Returns for Canadians. I calculated the Geometric Mean (average) using the GEOMEAN function on an Excel spreadsheet.
This is the 271st blog post for Russ Writes, first published on 2024-12-02
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.
Image by Gerd Altmann from Pixabay