Seven Warning Signs of Market Gurus (and which forecasts you can trust)
Much as I want to know the future, I’ve long since recognized the dangers of our addiction to predictions, which are usually heralded by so-called market gurus. I’ll give you seven surefire ways to spot those purveyors of bad advice, but first let’s look at a far more useful set of forecasts.
For a prediction to gain media exposure, two things are critical. First is precision. We want to know with a great degree of certainty what the stock market will return in 2018. Second is compelling logic. We want to feel confident that our nest egg and that of our client’s is invested on a firm footing.
Unfortunately, there is a mountain of evidence that market predictions aren’t just lousy; they are less accurate than random guesses. While not as emotionally appealing as a single-point prediction, probabilistic forecasts are more useful because they allow you to evaluate the consequences of possible scenarios.
Here are my probabilistic market predictions and, even more importantly, the implications for your clients’ portfolios. Each prediction is made with a 95% confidence level, meaning I expect actual outcomes to be within this range 19 out of every 20 years.
1. The U.S. stock market will return between -21.7% and +34.7%
Stocks have historically earned approximately 7% after inflation. I just can’t resist the temptation to lower it a bit to 5% based on fairly rich valuations. So my midpoint is a 7% nominal return, or a 5% real return, if the Fed hits its 2% target inflation rate. Next, I take the 15-year historic standard deviation of 13.85% from Morningstar and apply two standard deviations to get a 95% confidence level. The Minneapolis Federal Reserve estimates the odds of a bear market being greater than my estimate at approximately 8%.
The implication is that stocks have a greater than 50% shot at beating inflation but are risky. We need only to look back to 2008 when U.S. stocks lost about 36%, which was a three-standard-deviation event, meaning once every 300 years.
A plunge could be caused by a natural disaster, a military conflict (such as with North Korea) or by a terrorist attack here at home. But let’s face it, if the plunge does happen, it’s likely that it will be caused by something we haven’t anticipated. The implication to your clients is, of course, that stocks are risky. The downside may be more important than the 34.7% upside since running out of money has a much greater impact on clients.
Are your clients taking any unnecessary risk?