Nobody Knows Nothing

I've been in this business a long time, and it never ceases to amaze me how the guru-of-the-day acts as if he or she has it all figured out and is happy to share their wisdom with anyone with a t.v. or a broadband connection. 

If you watch the news, and follow the advice of blow-dried and manicured investment experts, you're doing it all wrong. There are no market wizards. Most of these talking heads are either talking their book or selling a book.

Tune into any media outlet and you’re likely to find an expert offering some kind of opinion on the future. The problem is that the experts you are most likely to see are least likely to know what they’re talking about.

They may know a great deal about their niche in the market, but this doesn't translate into better forecasts of future events. No matter how much knowledge or experience these experts have at their disposal, there's no escaping the hard truth that nobody knows nothing.

The fact that no one can predict the future may seem obvious. But odds are you will tune-in to your favorite media source to hear what their experts have to say.  After all, if they don’t know what's going to happen next, then who does?

In 1985 Dr. Philip Tetlock embarked on a mission to find out whether experts could predict future events. Over a span of 20 years, he interviewed 280 experts about their level of confidence that a certain outcome would come to pass. Forecasts were solicited across a wide variety of domains, including economics, politics, climate, military strategy, financial markets, legal opinions, and other complex fields with uncertain outcomes. In all, Tetlock accumulated 28,000 forecasts from these experts.

Tetlock focused his research on measuring forecast correlation; that is, how experts’ confidence in a particular forecast correlated with the actual percentage of times that their forecasts worked out. If experts were confident in their forecasts, when they assigned a 60% probability that they would be proven correct, those forecasts should prove correct about 60% of the time. 

However, when Tetlock measured the actual realized correlation of expert forecasts, individually and in aggregate, he discovered that experts’ confidence in forecast outcomes did not correlate with actual results.

• Experts are less well calibrated than what might be expected from random guessing.
• On average, experts delivered forecasts, and confidence in their forecasts, that were less well calibrated than one might expect from random guessing.
• Not one expert distinguished him/herself with better-than-random calibration.
• Experts expressed more extreme forecasts, with greater confidence, and were thus less well calibrated in their own field of expertise than when making forecasts outside their own domain.
• Experts who more regularly appeared and were cited in media were less well calibrated than those who labored in obscurity.
• Experts who typically expressed less confident forecasts exhibited higher calibration, but were still worse than random.
• The average of all forecasts were better calibrated than any individual experts.
• Simple algorithms like continuation of trend in the short term, or reversion to the mean in the long term, outperformed all the experts, and delivered better than random forecasts.

Tetlock discovered that the primary mechanism that most people rely on to make decisions every day – expert judgment – is fundamentally flawed. This has profound implications for decision-making in every dimension of life, but it implies a complete overhaul in how people think about their investments.

If you work in the financial industry your livelihood probably depends on giving the impression that you, or your firm, can see into the future and predict what's most likely going to happen next. This is understandable. Every Wall Street firm indoctrinates new recruits to believe that their experts are the best in the business. How else will a new recruit be able to take an account away from a competitor? 

But in reality, it's little more than guesswork, and some are better than others at the guessing game. That's why we have Warren Buffett, Peter Lynch, and other giants of the investment business. They know how to calibrate their guesses, and they never lose sight of the fact that they are just guessing.

Is Warren Buffet a Guru? Maybe. But he would say no. He would say that he has a process in place that guards against magical thinking, like predicting the direction of the market. He analyzes companies better than most, and he makes huge bets on the ones he thinks will be winners in the future. But he's betting - he's not predicting. There's a difference.

“That’s what diversification is for. It’s an explicit recognition of ignorance.” – Peter Bernstein

I was very fortunate to meet and talk with Peter Bernstein in the late 1980s. He was one of the greatest minds in our business. In our business, we embrace uncertainty head-on by adopting systematic strategies founded on the principle that we can’t know the future. That means focusing on diversification. Strategies like the Global Market Portfolio, factor-based strategies, and diversified risk premia strategies are all rational ways to maximize diversification against an uncertain future.

Investors in the Global Market Portfolio (GMP) hold all liquid global assets in proportion to market capitalization. As such, they express the belief that the optimal asset allocation reflects the average bets of all market participants. Importantly, investors in the GMP eschew forecasts of future asset class returns altogether.

A thoughtful approach to markets starts with deep introspection about how we believe markets work. ​

Voltaire said that “Doubt is not a pleasant condition, but certainty is absurd.” While it is natural to seek comfort by putting faith in expert judgment, the fact is there is no wizard behind the curtain. As a result, the cornerstone of any successful long-term investment plan is learning how to deal with ambiguity. 

This means embracing real global diversification in ways you probably haven’t contemplated before, and perhaps introducing alternative sources of return that don’t rely on forecasts. 

The Only True Passive Benchmark: The Global Market Portfolio

​The vast majority of investable assets for both private individuals and institutions is ‘long-term money’, with a time horizon in excess of five years. This kind of capital will generally benefit from full exposure to a diversified portfolio of risky assets in order to maximize the opportunity for excess returns above what might be earned from cash. The question is, what might this portfolio look like?

In 1964, Bill Sharpe demonstrated that, at equilibrium, the portfolio which promises the greatest excess return per unit of risk is the Global Market Portfolio, which is composed of all risky assets in proportion to their market capitalization. Many investors will be familiar with this concept from their experience with market cap weighted indexes like the S&P 500. These are the ultimate passive investments within an asset class. However, it is not as obvious how to apply this concept across asset classes.

Since the Global Market Portfolio represents the aggregate holdings of all investors, it is the only true passive strategy. It is also the truest expression of faith in efficient markets. All other portfolios, including the ubiquitous 60/40 ‘balanced’ portfolio of (mostly domestic) stocks and bonds, represent very substantial active bets relative to this global passive benchmark.

The flaw in the theory of global diversification is that it ignores risk. This is a flaw that can be corrected with a simple overlay to the portfolio. By reducing or avoiding equity exposure during economic recessions, an investor can realistically add 3-5% to their annual returns. How is this done?

There are a handful of reliable recession forecasting services available to investors, among them NoSpinForecast.com, RecessionAlert.com, and my own model which is available to subscribers to my monthly newsletter. Knowing the probability of the onset of a recession is extremely helpful for an investor. We can never know with certainty, of course, but we can get close enough to mitigate the damage to risk assets like equities that accompany recessions.

If you don't think that a boost of 3-5% to your annual returns is a big deal, then you don't understand the power of compounding. Over a 20 year period, a 3% boost to returns works out to a doubling of your final account value. As Albert Einstein said, the most powerful force in the universe is compound interest.