Summer Update
Of Suckers & Seers - The Problem with Investment ‘Experts’

The Polson Higgs Wealth Management team, 19 February 2010

Welcome to our Summer Update

In this edition of our Update we review returns for the past three months to 31 December 2009 but first we revisit a 2005 study of more than 80,000 ‘expert’ forecasts that found, ? wait for it, ? that experts were no better at forecasting than non-experts and both were worse than simple rule-based options.

Is our belief in experts well-founded?

In the 2005 study(1), Phil Tetlock, a professor at the Haas School of Business at the University of California, Berkeley, set out to look at the ability of expert forecasters in the area of politics and economics. He assembled 284 people whose professions included “commenting or offering advice on political and economic trends”. He asked them to forecast the probability that various situations would or would not occur, picking areas both within and outside their areas of expertise.

By 2003 he had accumulated 82,361 forecasts, which provided him a database to evaluate. He found that the experts barely, if at all, outperformed informed non-experts and neither group did well against simple rules and models.

He divided his forecaster’s outcomes into 3 states: “better”, “same” and “worse” than simple chance would predict. The professional forecasters frequently did worse than applying a simple rule - that each state is equally likely (the 50/50 bet).

As Professor J. Scott Armstrong from Wharton Business School stated, “no matter how much evidence there is that seers(2) do not exist, the suckers will still pay for the existence of seers.”

In our arena there are plenty of investment advisers and stock brokers who will pretend that they can pick a winner from the pack or pick a winning cluster of shares (a concentrated portfolio) for their clients.  Or, even more clever, they can tell when it’s the right time to change emphasis, say exit international shares and buy local property instead. They believe they can do this because they’ve done their research and identified all the issues.

Generally the public believe them. It is a normal human foible to want to believe in the power of experts.  When an investment expert gives the impression they know something that will provide a special advantage, people flock to them.

We argue that the real experts in the investment field are the ones that ‘know what they don’t know’ and don’t pretend to be able to do things they can’t do. For instance, investment experts can’t -

1. Tell which share is going to do better or worse than any other share any better than chance or luck could tell
2. Tell when shares are going to perform better than property or bank term deposits
3. Tell what the New Zealand dollar is going to do against the British pound, the US dollar or any other currency
4. Tell whether it is going to rain on the triathlon this weekend

The newspapers and the marketing material produced by many investment houses are full of such wild claims.

In the face of uncertainty, as the Tetlock study showed, it is best to rely on simple rules rather than try and work out from research what is going to happen. When we can’t foretell future investment conditions, let’s spread our risk and take a 50%/50% position; a bit both ways. A bit here, a bit there; some now, some later. Simple rules are better than expert forecasts. That is the message of the Tetlock study. This translates in our business to the importance of not trying to pick the best time to enter the market and not picking a concentrated portfolio of just a few shares. It suggests that any time is the right time to invest, or, averaging in over 6 months as an example of a simple rule at work. It suggests that diversification across the entire world of investable assets is the right approach, not favouring any one sector.

In this business it pays to know what we don’t know. The real danger is getting involved with advisers who don’t know what they don’t know.

How did portfolios perform in 2009?

The year 2009 consisted of two parts. The first period of January through to the 9 March saw the tail end of the Great Financial Crisis and its impact on financial markets. The bottom of the market occurred on 9 March 2009 simultaneously around the world, give or take a few hours. International markets fell about 25% in those first three months with the impact in New Zealand dollars reduced to -12% once the fall in the New Zealand dollar was taken into account. You will remember it was a very discouraging time for us all.

The second part of the year from mid-March to December was pretty much upwards all the way. For those nine and a bit months markets rose 67% in the US and elsewhere they were up 50% or more. Again, the New Zealand dollar rose to take the shine off it with international markets up 20% in our terms.  The standout market in our currency was Australia, which rose 51% over that time. Those percentages were off a very low base so they were always going to be huge.

In the table below the 1 year returns are showing a recovery while the 5 year returns are ‘getting there’ despite our markets still being well below where they were in October 2007. 

On average, share markets still need to grow by 35% to get back to their October 2007 highs.

We still have some way to go.

PHWM Portfolio Returns to 31 December 2009

These portfolios include the standard allocation to New Zealand cash, fixed interest and shares and the Plan B international pools.
In this respect the mixes assumed below may differ from your portfolio. For 3 & 5 years returns are per annum.

After investment management costs but before Adviser fees and the Issuer/Administration fee which vary according to portfolio size. This table goes back to the inception of the Plan B portfolios in New Zealand, 20 May 2005. PHWM didn’t begin using Plan B portfolios until October 2007 and so the longer dated returns are indicative only.

How have recent events affected ptfolios?
 
For the first six weeks of this year we have had another small leg down in the value of markets. The world is worried about the Greek economy and whether they can pay their debts (and Spain, Portugal and Italy as well). China has started to try and cool its red-hot economy by reducing the supply of money and although that’s probably a good thing it is a portend of what every other country has ahead of them as they tighten monetary policy to avoid excessive inflation.

Over this time the New Zealand and Australian markets have fallen the most, around 4%, whereas the US is ‘about even’ taking currency into account.  The rest of the world is down about 3%. Overall your diversified portfolios are down around 1% since the end of last year.

1. Tschoegl, Adrian E. and Armstrong, J. Scott, Review of: Philip E. Tetlock. 2005. Expert Political Judgement: How Good Is It? How Can We Know? (June 29, 2008). Available at SSRN: http://ssrn.com/abstract=1153126
2. A ‘seer’ is someone who can foretell the future

Please don’t hesitate to give any of the team a call to discuss these or any other matters.

Polson Higgs Wealth Management Limited's disclosure document (116KB, Adobe PDF).

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