It’s that time of year again when the financial commentators look back at the last 12 months and ahead to the next 12 and try to make sense of it all.
Which investments performed best, and which ones the worst? Why did they do so well or so badly? And how do we need to position our portfolios for the year ahead?
It’s human nature to want simple answers to complex questions. We crave a sense of certainty and a sense of control. That’s why we warm to narratives that seem plausible or reassuring.
Of course, the journalists who write these articles, and the pundits who contribute to them, have their own motivations. For a start, this sort of forecasting is expected of them; it’s seen as part of their job. They no doubt enjoy it too; explaining market trends and predicting future performance is fun and engaging.
But does this annual tradition actually add any value for investors?
Nobody really knows
The truth is, there are all sorts of possible explanations, for example, US stock prices reached new highs in the run-up to Christmas, despite 2023 being a challenging year for investors generally. But nobody knows for certain why markets behave in the way they do.
As for trying to predict how different investments will perform in 2024, that’s a complete waste of time.
The behavioural finance expert Joe Wiggins recently wrote that predicting market performance over the next 12 months requires three things. First, we need to identify known issues or developments that will influence investor sentiment in 2024 and accurately predict them.
Secondly, we need to identify unknown issues that will influence sentiment and correctly forecast those as well. Finally, we need to foresee how markets will react to these known unknowns and unknown unknowns.
Of those three things, Joe rightly points out, the first two are impossible to do, and the third is extremely difficult.
“Although this may seem glib,” he writes, “it is not. It is exactly what is required to make such a forecast. It is a prediction of the market’s reaction to unpredictable events and events we haven’t even thought about.
“The more we see these types of predictions, the more people think that equity markets are somehow stable rather than noisy, and that investing is about making short-run estimates of impossibly complex things.
“We need to spend less time on spurious forecasts and more time on educating investors about what really matters.” (1)
So what does really matter? The key is to have a plan. You need to know why you’re investing in the first place and what you’re looking to achieve.
You also need to know your capacity for risk. How much risk do you need to take? How much can you afford to take? And is that a level of risk you feel comfortable taking?
If you’ve correctly identified your risk capacity and have a portfolio that matches it, and you know that you’re on target to achieve your goals, there’s no point in paying any attention to forecasts. It’s totally irrelevant which investments have gone up or down and which investments the “experts” say you ought to invest in next.
That’s one of the benefits of working with an evidence-based financial planner: you don’t have to worry about whether or not you’re doing the right thing.
Of course, you can acknowledge, on an intellectual level, that ignoring investment tips and forecasts is the logical approach. But we’re all human, and it’s harder to do in practice than in theory.
It’s particularly tempting to invest in a particular stock or fund because you’ve read in the media that it’s on a really good run. The urge to bail out of an investment after prolonged poor performance can also be very strong.
Nothing lasts forever
An important concept to remember, then, is reversion to the mean.
Investments can produce returns that are very much higher, or lower, than their long-term average for extended periods.
But when you zoom out and look at the bigger picture, you’ll see that they eventually tend to move back towards their average. Outperformance is followed by underperformance and vice versa.
Smart investors use mean reversion to their advantage. They realise that if a particular asset class has been on a good or bad run, it won’t go on performing well or badly indefinitely.
So they remain patient and disciplined, they focus on the long term, and they broadly diversify across different asset classes. Of course, there will almost always be something in a diversified portfolio that’s not performing well, but smart investors realise that the trend will eventually reverse.
Something else that smart investors do is to rebalance their portfolios from time to time, taking profits from an asset class that’s done well, and reinvesting that money in one that’s done less well.
By ignoring short-term performance, and by diversifying and rebalancing, investors really can make mean reversion their friend.
Have a great Christmas. And remember, don’t indulge in investment title-tattle that’s not worth the paper it’s printed on. Your time is far too precious to waste on that.
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products.
Robin Powell is a journalist, author and editor of The Evidence-Based Investor.