Building and managing a portfolio
Robust across all
It’s that silly time of year. It stuns me to see a constant stream of forecasts for the economy, inflation, interest rates and the outlook for the stock market. The big investment banks and brokerages put them out and pundits sound off on them endlessly. They are typically paired with tactical asset allocation or tactical portfolio allocation strategies. It all sounds very smart and sophisticated.
There are two problems. First, reliable forecasting is impossible.
Kahneman refers to studies by Philip Tetlock concerning expert predictions. Tetlock examined 80,000 predictions on political and economic trends. “The results were devastating. The experts performed worse than they would have if they had simply assigned equal probabilities to each of the three potential outcomes.”
More knowledge leads to worse predictions
Kahneman’s conclusion is that: “Those who know more forecast very slightly better than those who know less. But those with the most knowledge are often less reliable. The reason is that the person who acquires more knowledge develops an enhanced illusion of her skill and becomes unrealistically over confident.” (Kahneman, Thinking, Fast and Slow. 2011) p219
The second problem flows from the first. Any investment process that depends on forecasting is bound to fail.
The dilemma
But here’s the problem. Every investment decision carries with it an implicit forecast about the future. There is no contradiction in this. Let’s see how Warren Buffett comes at this problem.
In the in the Berkshire Hathaway Chairman’s letter for 1988 Buffett wrote: “As regular readers of this report know, our new commitments are not based on a judgment about short-term prospects for the stock market. Rather, they reflect an opinion about long-term business prospects for specific companies. We do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activity will be a year from now.” (Emphasis added)
He has written elsewhere: “When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.” (Buffett W. E., The Essays of Warren Buffett: Lessons for Corporate America. Lawrence A. Cunningham. 1998) p.63. (Emphasis added)
So, he acknowledges that he relies on forming “an opinion about long-term business prospects for specific companies.” This is surely a forecast or prediction of a kind. What he says he is doing is analyzing specific businesses within his area of competence.
Virtually certain
Warren Buffett describes his approach thus: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (Buffett, 1998) p93 (Emphasis added)
Tactical asset allocation and tactical portfolio weighting
Here is what investors must avoid. Tactical asset allocation is a very specific investment style. It is typically a variant of the classic 60/40 stock/bond approach. Adherents (including some advisors) say you should increase or decrease your weighting of stocks (the fine-tuning part) based on the outlook for the stock market, the economy, future interest rates and other factors.
This investment style incorporates market timing. Market timing is the effort to buy a stock or stocks when the outlook is good and sell them when the outlook darkens. It is one of the most sure-fire ways of losing money in the stock market. It comes freighted with all the perils of behavioral biases.
Not only is such forecasting essentially impossible, but there is often no correlation between the economy and the stock market. The stock market and the economy very often do not march to the same drummer. They are often out of step. So, trying to pursue stock market timing based on one’s outlook for the economy is not a good idea.
A variation on this theme is tactical portfolio weighting. The suggestion here is to overweight different sectors such as consumer discretionary or industrial or utilities, for example, depending on where we are in the business cycle or depending on the outlook for the economy or interest rates. Again, this is market timing pure and simple and is a fool’s game.
What to make of all these forecasts
Having cautioned investors against basing investment decisions on the outlook for the economy, interest rates or the market, the question naturally arises what to make of all these forecasts. I read a lot of this material avidly. What I’m trying to do understand the economy, the impact of interest rates and the ebb and flow of the stock market. It puts everything in context. It allows you to maintain perspective. It allows you to create a “theoretical framework” for events, to use George Soros’ expression.
George Soros writes: “My financial success stands in stark contrast with my ability to forecast events.” He refers to both financial markets and the real world. He says: “Even in predicting financial markets my record is less than impressive: the best that can be said for it is that my theoretical framework enables me to understand the significance of events as they unfold – although the record is less than spotless. One would expect a successful method to yield firm predictions; but all my forecasts are extremely tentative and subject to constant revision in the light of market developments. Occasionally I develop some conviction and, when I do the payoff can be substantial; but even then, there is an ever-present danger that the course of events fails to correspond with my expectations.” (Soros, The Alchemy of Finance, Reading the Mind of the Market, 1987,1994) p301
Conclusion
Let’s do a test. This from the November 25th edition of The Economist: “Goldman Sachs expects growth in America to be robust, at 2.1%, around double the level that economists at UBS foresee. Some banks see inflation falling by half in 2024. Others think it will remain sticky, only dropping to around 3%, still well above the Federal reserve’s target.” What are we to make of this? Answer – Our investment decision making must be robust across all these forecasts and across an even wider range of outcomes. There is nothing in these or any other forecasts I have seen for the economy, interest rates, inflation or the stock market that make me want to vary my asset allocation or portfolio.
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For readers wishing to learn more about finding good stocks and stock selection check out the Motherlode Chapter 40. Finding and studying companies to invest in
This Chapter continues with these Sections:
40.02 Positive media stories generally indicate the end of superior performance
40.03 Analysts’ reports and other sources
40.06 The earnings estimate game
40.07 Herding and the short term
40.08 Reading deeper in sell side analysts’ reports
40.09 An aside about facts vs opinions
40.10 Analysts’ reports continued
40.11 Conclusions re sell side analysts’ reports
40.13 Company website, quarterly and annual reports
40.14 Meetings with company officials
40.16 Scuttlebutt and other sources
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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