Investing is tough for a lot of people because they expect they can trust the opinion of experts. Yet in the world of markets, the so-called experts get an awful lot wrong. However, if you look carefully at the kinds of errors they make, you can weave a reliable investment approach from the cloth of human folly.
For example, look at earnings estimates. Wall Street analysts publish earnings estimates for stocks. Investors often aggregate these estimates to come up with a “consensus.” When earnings come out, the media will talk about how such and such a company beat or missed the consensus. A good beating can send a stock up strongly, while a miss can send it tumbling.
Many investors watch these estimates like hawks and rely on them in their buy and sell decisions. The problem is these estimates are wrong of-ten, and by a wide margin. One large study covered nearly 95,000 consen-sus estimates from more than two decades. It found the average estimate was off by more than 40 percent!
David Dreman writes about this in his book Contrarian Investment Strategies. Digging deeper, he finds the analysts made consistent errors in one direction: they were too optimistic.
So if you put the two together, you quickly come to realize the odds of you owning a stock that doesn’t suffer a negative earnings surprise is pretty small. In fact, the odds of a single stock getting through four quarters with-out a negative surprise of at least 10 percent worse than expected are only one in four.
I don’t mean to pick on analysts only. As a species, we are by nature optimistic—at least most of us are. It’s the winning trait in the evolutionary derby, and we need to invest taking into account that optimism.
To illustrate his findings, Dreman included a great chart that showed consensus forecasts for interest rates over a period of time. One big thing sticks out. People tended to forecast a future that closely approximated the present. Reality was much more volatile. Forecasters face many surprises.
So, it is important to knock down the pedestals on which forecasters sit.
Jason Zweig and Rodney Sullivan recently published a collection of Benjamin Graham’s essays and speeches in Benjamin Graham: Building a Profession. Graham is widely cited as the dean of security analysis. And the title of this book is inspired by a witty line by Adam Smith (pseud-onym for commentator George Goodman). Smith wrote, “The reason that Graham is the undisputed dean is that before him there was no profession and after him they began to call it that.”
As I read over these essays—some of which I remember having read in other places—one theme stuck out that is good to keep in mind today.
Speaking of the financial community generally—the gamut of analysts, economists, investors and the like—Graham laid out this criticism: “They tend to take the market and themselves too seriously. They spend a large
part of their time trying, valiantly and ineffectively, to do things they can’t do well.”
What sorts of things? Among them is “to forecast short- or long-term changes in the economy, and in the price level of common stocks.”
Many people spend a great deal of time trying to guess where the economy or the stock market is going. And yet, there are countless studies that show the folly of such forecasting.
James Montier of GMO, a global money management firm, highlighted how poor economists are at forecasting. He concludes,
Attempting to invest on the back of economic forecasts is an exercise in extreme folly, even in normal times. Economists are probably the one group who make astrologers look like professionals when it comes to telling the future. . . . They have missed every recession in the last four decades! And it isn’t just growth that economists can’t forecast: it’s also inflation, bond yields, and pretty much everything else.
He shares a chart that captures the consensus GDP forecast and how GDP really fared. It’s interesting to see because one conclusion immedi-ately jumps out at you. Take a look at the chart below and see whether you agree.
Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1
’72 ’75 ’78 ’81 ’84 ’87 ’90 ’93 ’96 ’99 ’02 ’05 ’08 ’11 10
8 6 4 2 0 -2 -4 -6
Economists: blind mice
Percent
Real GDP YoY % Consensus Forecast GDP
Note how the consensus never gets the extremes. The consensus al-ways forecasts a middle ground. The same general pattern of error holds for all kinds of forecasting, including forecasted earnings per share and market prices. The problem is, of course, that the extremes are where you make (or lose) a lot of money. Consensus forecasts aren’t worth much, whether right or not.
Finally, Howard Marks at Oaktree Capital once put together the fol-lowing schematic, which makes things clear. It shows you the return you get from each type of forecast, based on whether it is accurate or not.
“Extraordinary performance comes only from correct non-consensus forecasts,” Marks writes. He uses the example of interest rates in 1978, which then stood at 8 percent. Most people thought they’d stay there. Bulls said they’d go to 9 percent; bears said they’d go to 7 percent. Marks says,
“Most of the time rates would have been in that range and no one would have made much money. The big profits went to those who predicted 15%
long bond yields. But where were those people? Extreme predictions are rarely right, but they’re the ones that make you the big money.”
Ben Graham’s greatest student was Warren Buffett—also a great ig-norer of forecasts. In his 1994 shareholder letter, Buffett showed he had taken Graham’s lesson to heart:
We will continue to ignore political and economic forecasts which are an expensive distraction for many investors and businessmen.
Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resigna-tion of a president, the dissoluresigna-tion of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%. . . . But, surprise—none of these blockbuster events made the slightest dent in Ben Graham’s investment principles.
Accurate Not Accurate
Consensus Forecast
Average Average
Nonconsensus Forecast Above Average Below Average
I often hear sweeping pronouncements made about the stock market and where it’s going from pundits and investors everywhere, as I’m sure you do too. I also notice how so many people take such guesses seriously.
However, I’m not going to suggest we should all stop guessing. That’s asking too much.
But I’d advise holding all such opinions loosely and with a great deal of humility. After all, how many people in March 2009 thought the market would rally 80 percent in less than two years? Not many, that’s for sure.
Yet, it happened. No one could have forecast the Gulf oil spill happening when it did, either.
Over the course of an investing life, stuff is going to happen—both good and bad—that no one saw coming. Instead of playing the guessing game, focus on the opportunities in front of you.
And there are always, in all markets, many opportunities. Yes, always!
Graham pointed out—in 1976—there were over 5,000 publicly trad-ed securities. (Today there are over three times that number, especially if you consider the international markets.) Then he said, “Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least 1% of the total list—say, thirty issues or more—that offer attractive buying opportunities.”
That’s true. When someone tells me they can’t find anything worth buying in this market, they are just not looking hard enough. With 10,000 securities today, even one-half of 1 percent is 50 names. Kind of makes you think, doesn’t it?