I am retired and take educated guesses on all things financial.

December 21, 2007

December 22, 2007: Beware of forecasters

The knowledge that chance has a lot to do with performance helps to clear up a few mysteries in the investment world. It explains why a fund that is at the top of the class one year seldom finishes near the top the next year, and why a so-called expert financial advisor who turns in a spectacular performance one year rarely does better than average the following year.

You should not disregard the record of a fund or an investment advisor, but you need to discover how that record was achieved (and whether the record you're shown is accurate).

Here are two suspect reasons that investment advisers use (especially the stock touts on cable tv and in newsletters):

Proven indicators: The assumptions behind almost all are foolish. You will hear of the 'Super Bowl Indicator" next month. We heard about the "World Series Barometer" last October. And the Ground Hog Indicator says that if the ground hog sees his shadow, interest rates will fall. There are probably several thousand more. If you have heard of one or more of these "proven" indicators, it has been blessed by chance and nothing more.

Persuasive indicators: If a computer sifts through the daily record of prices for the past twenty years, testing thousands of different moving averages, it is bound to find a few that confirmed - quickly and accurately- each turning point in the market. But there is no reason they will have to work correctly the next time. No indicator has the power to forecast the future.

Many investors and advisers like to feel that, because they spend a great deal of time on research, they're approaching their investments scientifically. But if the research is simply a hunt for patterns that have been repeated, it isn't science at all. In fact, it's no more scientific than betting on the number 6 at the roulette table whenever number 12 has come up - simply because twice before you saw a 6 follow a 12.

If a relationship has held two times, five times or even twenty times in the past, that fact isn't -of itself- sufficient reason to expect the relationship to hold even one more time.The past is full of meaningless coincidences that are waiting to be discovered by investors and advisers.

Many of the investor's best laid plans go wrong because they assume that some past patterns will continue into the future. Tt is tempting and so "reasonable" to rely on the track record of a trading system, an advisor or an indicator. Too often, these all fall apart as soon as you risk your money.

When someone makes market predictions, or offers you an investment tool, system or track record, ask why it works. The answer, "See, it DOES work", is not good enough. Even a graph claiming to show a strict relationship between an indicator and a particular result is nothing more than a curiosity. A graph of a coin-flipper's results would be just as impressive.

If you are given a reason or rationale you don't understand, treat it is a poor reason. Don't assume it is over your head. It may,in fact, be beneath you.

Investing isn't child's play. Don't believe that someone can reduce it to a simple task of following an indicator or relying on a perfect track record.

Make sure you hunt down a copies of last year's financial publications and see how ridiculous the "year ahead" predictions were in almost all cases. And how infallible gurus or systems faired below the proverbial monkey throwing darts at the Wall Street Jounal stock tables to pick winners.

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