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The perils of making investment predictions

The perils of making investment predictions

May 3, 2012

crystal ball with a graph insideIt is reassuring that those making predictions in the wonderful world of sports are just as unlikely to be correct as those making predictions in the world of investing.

Losing a wager with a sports bet will cost you some pride and potentially a few dollars. Getting it wrong with your investments could cost you a comfortable retirement.

The Stanley Cup playoffs are underway and at least on paper, several predictions seemed reasonable if not probable, but the actual results were far different.

Motivated by their seventh game defeat last year, many thought the Vancouver Canucks would repeat again as a Stanley Cup finalist and would win the coveted Holy Grail.

For the second straight year, Vancouver won the President’s Cup for the team with the highest number of points in the NHL during the regular season. Their first round would be relatively easy because the top team in each conference plays the eighth place team.

The Boston Bruins won the Stanley Cup last year and as good as they are most felt they could not get by the Pittsburgh Penguins in the east. Sidney Crosby had finally returned from his concussion injury and the best player in the world was going to be too much for the Bruins to handle.

Many sports fans predicted that the first round of the Stanley Cup playoffs would go according to plan. Some teams are just too strong.

Well if it is any consolation to those who make investment predictions, their sports counterparts have as much of a problem as they do with “crystal balling” the future.

Round two of the Stanley Cup playoffs are underway and the three powerhouse teams mentioned above were eliminated in the first round. So much for predictions.

Investors make predictions frequently which are often the basis for investment decisions. Those decisions are critical to your financial well-being so it is important to understand if predictions can be made successfully.

The logic is if predictions prove to be accurate, then using them will add value to your investing process. However, if they are not accurate then it is more prudent to avoid making them.

During the 1980s, researchers undertook a major study of the ten year investment performance history of 100 large pension plans in the United States.

Over ninety-three percent of normal volatility could be attributed to asset allocation. Effectively, how much of your investments are in stocks or bonds is the most important investment decision you make.

Less than seven percent of the normal market fluctuations could be attributed to security selection or market timing. Despite this knowledge, many investors make predictions on what stocks to purchase and when to make that purchase.

If investors were successful in predicting the future they would only influence under seven percent of their investment performance. Success or failure is determined by asset allocation; not by attempting to predict and implement short –term buy and sell decisions.

If predicting was reliable then professional money managers would be able to turn that skill into successful investment returns. That does not happen.

Academic research shows professional managers do not beat the market returns over time; therefore, the predictions they make add no long-term value and are often wrong.

Historic performance figures support this research and show that professional managers’ investment returns are less than the average market return after their fees have been deducted.

Using the combination of research and historic past performance, we would like to make a prediction. If you try to predict the future and make investment decisions accordingly, we predict you will not be successful.

Predicting is enjoyable so continue to bet on your favourite team. Investment predictions do not work overtime, so avoid them when managing your investment portfolio.