Why Are One-Year Market Forecasts Often Off-Target?
As a financial advisor, I’m often asked what I think the market will “do” in the year ahead.
I wish I knew. If I did, I wouldn’t need to work for a living. I would be busy docking my personal yacht on my private island.
Lacking psychic powers, we must instead heed the imperfect, but important science of investing: Near-term market returns are unknowable – driven by news that has yet to occur, juiced by the collective reactions of all investors combined.
Instead, we can make informed estimates for any given market’s expected return by thinking in terms of a range of possible returns rather than impossibly precise predictions. We can use statistics to estimate the range.
To illustrate, let’s say historical data informed us that U.S. large company stocks have delivered an average annual return of 10%, with a standard deviation of +/–20%. If we assumed approximately the same moving forward, for any given year:
- There’s a 50/50 chance returns will be either higher or lower than the 10% annual average.
- There’s a 68% chance returns will be within one standard deviation (20%) of 10%. So, there’s a decent chance returns will land between –10% (10% – 20% = –10%) and +30% (10% + 20% = +30%).
- There’s a 95% chance returns will be within two standard deviations which means between – 30% and +50%.
- But returns could be even higher or lower. For example, there’s a 5% chance of earning more than +50% or less than –30% in any given year.
To make it more confusing, there is the concept of normal and non-normally distributed variables, so what I suggest above is close but not precise.
Bottom line, next time an “expert” tells you what the market will do this year, remember they can’t know for sure. Understanding how far flung the range of possibilities tend to actually be will help you avoid relying on false prophets for your personal investment decisions.
To help you zero in on your personal financial goals, stay tuned for a future edition, where we’ll discuss how to control the range of possible outcomes over both shorter and longer timeframes.
Written by John A. Frisch, CPA/PFS, CFP®, AIF®, PPC®