When the crystal ball is clouded

‘The clairvoyant society of London will not meet this Tuesday because of unforeseen circumstances.’ An advertisement in the Financial Times.

Jeremy Blatch

Tuesday, 1 October 2024, 18:23

Markets are made up of people, and market prices fluctuate because of the human condition, fear and greed. Assuming highly paid and skilled professionals can make the right decisions in their chosen vocation, we pay them to see into the future. Sadly, exhaustive findings from ... peer review studies reveal that this seldom is the case.

At a time when thousands of children presented with symptoms of a sore throat, a survey by the American Child Association of 1,000 11-year-olds in New York City found that 611 had their tonsils removed. Of those who still had sore throats on reexamination, a further 174 were selected to have their tonsils removed. The remaining 215 were reexamined by another group of doctors who recommended 99 have their tonsils removed. After three further reexaminations only 65 children remained with their tonsils intact. Numerous studies have shown that radiologists failed to diagnose lung disease in about 30% of X-ray plates despite the clear presence of the disease on the film.

We can liken this to making price predictions in the capital markets. Why do we allow ourselves to make speculative investment decisions based on predictions of so-called investment and market gurus. Having managed money successfully in the markets for some 30 years, I know that it is foolish in the extreme to attempt to predict price movement.

Here are five reasons why security analysts have such difficulty in predicting the future: a) the influence of random events, b) the reporting of dubious reported earnings through creative accounting, c) analyst errors, d) loss of the best talent to sales or portfolio management, e) conflicts of interest for analysts at firms with large investment banking operations. Each needs to be examined more closely for a better understanding, which is beyond the scope of this article.

All money managers have three main methods available to them to make risk adjusted returns on capital security selection, market timing and diversification. Get the first wrong and you will not get out of jail free! Investing in a broad low-cost index fund allows us to negate the risk associated with security selection and market timing. You may be fortunate to be able to invest with a handful of investors who consistently beat the market, but you will need a very deep pocket to play, and whether their success is skill or luck is difficult to ascertain. Why try and look for a needle in the haystack when you can buy the haystack? High fees, high turnover, trading and transaction costs eat away over time at investor returns. Accept the market rate of return and the market risk in a broad index. Don't bet the farm, however good the idea. Diversify and stay in the market. And above all, avoid market predictions. The market can remain irrational longer than most of us can remain solvent.

The author (jb@ehh.gi) is a member of the Society of Trustees and Estate Practitioners and an investment counsellor. The comments and observations by the author are a reflection of his opinion and do not constitute an offer to buy and hold securities, nor does he receive any remuneration of any kind from names referred to.

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