Thursday, October 20, 2011

How Not to Set Investment Strategy

"Prediction is very difficult, especially about the future"

One of the biggest mistakes that investors make, in my opinion, is to try to overlay their views on the economy or interest rates on their investment strategy.

It seems to make logical sense: first you forecast the economy, then the direction of interest rates. Once you've figured this out, you turn your attention to what stocks or bonds will provide the best returns under the scenario that you expect.

Problem is, the accuracy of most forecasts - especially about the economy, interest rates and the stock market - are usually poor at best.

The academic literature is full of examples of how many of the most prominent and learned among us have failed to anticipate changes in the economy. It's not for lack of trying, but rather that it's just too complex.

Take interest rates, for example. Here's a short note written by John Carney the CNBC blog Net, Net:

The latest note from James Bianco points out that Bloomberg’s monthly survey of economists almost always forecasts high rates for 10-year Treasurys in the next six months.

Since 2002, Bloomberg has been asking economists where they think interest rates will be six months into the future. Out of the 104 surveys completed, 100 of them forecast high rates in six months.

Every single survey for 2011, for example, the majority of economists polled forecasted higher rates.

Interestingly, the economists are always right when predicting falling rates—although this has only happened four times so far so the sample may be too small to matter.

Now, with interest rates at 60-year lows, what's the next direction for rates?

Truth is, no one knows for sure.

It seems to me that one should focus their investment attention on sectors that offer the most value under a variety of different scenarios, no matter how far fetched they might appear.

*This quote is usually attributed to Niels Bohr, a prominent Danish physicist, although Bohr himself attributed it to others. Whatever - I like the quote.