By GARY BROOKS — Contributing Writer
In the past week, while reading a variety of investment market analyses and outlooks, I reviewed investment return forecasts from three firms, each applying a different global view to a different predictive model.
They all use sophisticated techniques combining economic conditions, stock and bond market data, interest rates and even investor sentiment to project what they believe is the most likely future performance of various types of investment assets.
It is interesting to read the rationale behind each forecast, but the only thing we know for sure is that they are all wrong.
I trust that the analysts and researchers generating forecasts are using credible methodology. But a complex system of global markets, responding to constantly changing influences, is unlikely to arrive at an outcome anywhere near even the most robust financial modeling.
And yet, what are you to do when this is the information that you have to work with for investment decisions and retirement planning? At best it will be inaccurate. At worst, not even in the ballpark.
Whatever degree of wrong it may be does not mean it is worthless, however. Put in the context of your personal situation, the information can bring logic to your investment approach.
CALIBRATING THE CRYSTAL BALL
Of the forecasts I noted, Fidelity produced a 20-year prediction. The forecast identified U.S. stock returns (after inflation) of 6.6 percent — very close to their long-term annual average. Investment-grade U.S. bonds were projected to return just 0.7 percent per year over the next 20 years by the Fidelity model.
A different view from institutional investment manager GMO projects returns over seven-year cycles. GMO forecasts negative real returns (after-inflation) for the broad U.S. stock market while “high quality” U.S. stocks add 3.7 percent beyond inflation on average over the next seven years. GMO forecasts negative after-inflation returns for almost all types of global bonds.
The five-year forecast presented by the asset allocation research team at Litman/Gregory projects five-year returns for U.S. stocks at essentially zero when adjusted for inflation. This assumes the subpar economic recovery continues. Litman/Gregory also expects U.S. bonds to generate neutral-to-lightly-negative average annual returns.
Even differing forecasts have some value because they provide a framework for decision making. In terms of investments, the forecasts help inform how to weigh stocks vs. bonds and alternative investments in a diversified portfolio. They can help identify the difference between risk and opportunity. In the case of these forecasts, they demonstrate that bonds have significant risk of not keeping up with inflation because of low interest rates. This may cause income-oriented investors to think much differently about their investments than they have over the past couple decades.
Whether it’s over five, seven or 20 years, the factors that influence forecasts will change many times. What’s more valuable than the numbers presented in the forecast is the element of preparation for a future that is certain to be uncertain.
PROCESS VS. LUCK
Where outcomes are uncertain, it becomes very important to trust in an investment process. Even if the process is only generally correct, as long as it is not precisely wrong, the investment outcome should represent progress toward goals.
Too many investors, applying hope as a strategy rather than trusting a well-conceived process, are reliant on luck.
“An investor with a flawed process can succeed on luck in the short term and have it be confused for skill,” Michael Mauboussin wrote in his book “The Success Equation.”
“An investor with a solid process may be unlucky in the short term but ultimately more successful over time.”
The reason application of a process will be more successful over time is often because it allows people to overcome human nature — the buy-high, sell-low condition of people responding to markets beyond their control. Occasionally, bad behavior is rewarded and a bad habit forms, causing people to believe they have more control over the short-term outcome than they actually do.
The only control you have over investment performance comes from the discipline you apply to your buying and selling process. Regardless, many people forget the process and respond only to the outcome, ignoring that, over time, the process will be more influential than luck on the overall investment success.
There is no single correct investment process. There are, however, hallmarks of a process that has a higher probability of success. It’s important to diversify globally, rebalance periodically and be mindful of expenses (taxes, transactions and management fees).
With these tenets of smart investing as your foundation, you can make modest adjustments based on forecasts to respond to growing risks or opportunities. Market prices will dislocate from reasonable justification from time to time in both directions. We know this will happen and it won’t be signaled in any forecast.
Gary Brooks is a Certified Financial Planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Old Town Tacoma.