What Degree of Forecasting is Bad for Your Wealth?

We all have to forecast the future to varying degrees. Whether it’s walking across the street or putting together a portfolio. Looking into the future is something we necessarily engage in thousands of times every day. Asset management of all type involves some degree of forecasting. Even the most “passive” investor must make some implicit forecast about how certain assets can be applied to future returns. Some investors extrapolate the past into the future while others are more involved in trying to forecast what the future will hold.

The question is not whether forecasting is smart or not. Some degree of forecasting is not only smart, but necessary. The more important question is whether your forecasting is hurting your portfolio performance. 

For instance, if you think you can guess where stocks will close on any given day and you engage in churning your account on a daily basis then you are engaging in a game where random market movements result in low probability bets. We know, with some certainty, that the markets are increasingly random in short intervals. There is no deterministic factor driving the daily price changes in the markets and why certain people buy and sell on certain days. Over the long-term, however, this becomes more deterministic. We know, with some high probability, that demand will increase for financial assets because those financial assets will tend to be tied to human output, which tends to expand over the long-term. This means that the current supply of financial assets is likely to be met with growing demand which will lead to higher prices.

Based on this simple logic, it’s smart to be a long-term financial asset bull, however, “the long-term” is a very vague concept when applied to our portfolios. After all, none of us really has a “long-term” investing horizon. Most of us have about 20-30 years of substantial financial asset accumulation and our financial lives have differing needs at different points in our financial lives. That “long-term” is more like a series of “short-terms”. So while it’s smart to forecast positive long-term returns we also have to be careful about how we apply that to our financial lives because we don’t want to assume we can ride out huge amounts of volatility in our portfolios if we can’t really afford that. In other words, most of us actually have shorter investment time horizons than we think and should probably be taking less risk with our savings than Modern Portfolio Theory might have you think.

Perhaps just as important is understanding how your short-term forecasts can hurt your near-term performance. As I’ve described before (see here and here), it’s important to understand your real, real returns. That is the money that actually goes into your pocket after the government takes their cut, your funds take their fees and inflation takes its share. A simple rule of thumb is that more forecasting and shorter-term forecasting means more fees which means lower performance.  Of course, it’s a bit of a balancing act as well because you don’t want to just assume that asset prices always rise over “the long-term” and that this theoretical concept can be cleanly applied to your portfolio. In essence, some degree of forecasting is necessary, but don’t let your forecasting excessively degrade your portfolio or result in excessive risk taking.

Related:

• Understanding the Intertemporal Conundrum
• Understanding your Real, Real Returns
• Understanding your Real, Real Returns – Fee Edition