Four rules for successful investing

The last two years have been tough for investors. Since 2007 shares have been on a roller coaster ride, first having their worst bear market in generations only to be followed by a rapid 50% or so rebound. And most other assets – bar government bonds and cash – have been on a similar ride.

Trying to time any of that has been particularly challenging. What’s more, there is no end of experts with widely differing opinions of where things are going. Some think that the next ‘Great depression’ is still just around the corner and that the recovery we have seen over the last six months is nothing more than a bear market rally.

Others, myself included, are of the view we have begun a new cyclical bull market with more upside to go. So what should investors do? At a more general level in undertaking investing there are several high level rules worth following. These are particularly pertinent in the current environment.

Forecasts must be treated with caution

The first thing to note is there is no easy way to predict where markets will go. If there was a foolproof method then I wouldn’t be writing this and you wouldn’t be reading it! The difficulty in forecasting is highlighted by the experience of economic forecasters.

Surveys of economic forecasts are regularly compiled and published in the media. It is well known that when the consensus (or average) forecast is compared to the actual outcome, it is often wide off the mark. This is particularly so when there has been a major change in direction for the variable being forecast, as has been all too obvious over the last two years. The difficulty with forecasting applies not only to economists’ forecasts for economic variables, but also to equity strategists’ sharemarket forecasts and share analysts’ forecasts for company profits.

Of course, this problematic track record has led to plenty of jokes about economists: economists were invented to make astrologers look good, an economist will know tomorrow why the things he or she predicted yesterday didn’t happen, economists have predicted five of the last two recessions, and so on.

There are numerous examples of gurus using grand economic or financial theories – usually resulting in forecasts of ‘new eras’, ‘great booms ahead’ or, as is more fashionable at the moment, ‘great depressions ahead’ – who may get their time in the sun but who also usually spend years either before, or after, losing money for those who follow their grand calls.

For example, the gurus who foresaw a ‘new era’ based on the IT revolution in the late 1990s looked crazy in the bear market earlier this decade. And sure, some did get it ‘right’ in terms of the global financial crisis last year, but as former Reserve Bank of Australia Governor Ian Macfarlane observed: “Everyone who predicted what has happened [in 2008] has been predicting it for 10 years”. And that’s not a great track record. There is no guru or expert who will get it right all of the time.

Prognosticators of doom can be particularly alluring. Firstly, because it’s easier to sound logical and inquiring when painting a bearish picture regarding the outlook than a bullish one. As J.K. Galbraith once observed “we can all agree that pessimism is a mark of a superior intellect”. Secondly, numerous studies show most investors are far more worried about a loss than a gain. This natural wariness and twitchiness on the part of investors probably explains why historically sharemarkets in stable countries have provided a higher return premium over safe assets like bonds and cash than can theoretically be justified.

Forecasts for economic and investment indicators can play a useful role but need to be treated with care.

• Forecasters are not immune from the psychological biases that beset everyone. These include the tendency to assume that the current state of the world will continue into the future, the tendency to look for evidence that confirms ones views as opposed to evidence that contradicts them, the tendency to only slowly adjust forecasts to new information and over confidence in their ability to foresee the future.
• Precise point forecasts, for example, that the US S&P500 will be at 1400 on December 31, 2010 – convey no information regarding the risks surrounding the forecast. They are also conditional upon the information available when the forecast was made. As new information appears, the forecast should change. Setting an investment strategy for the year ahead based on forecasts at the start of the year and making no adjustment as new information arrives is often a great way to lose money.
• Economic forecasts can be self-defeating, for example, economists’ forecasts for a recession in Australia this year were in a large part headed off by fiscal and monetary stimulus which themselves were a response to forecasts for a recession.
• When it comes to investment management, what counts is the relative direction of one investment alternative versus others – for example that shares outperform bonds – the precise point at which they end up is of secondary importance.
• The difficulty in forecasting financial market variables is made harder by the need to work out what is already factored in to markets. And rules of logic often don’t apply in investment markets.

The well known advocate of value investing, Benjamin Graham, coined the term “Mr Market” as a metaphor to explain the sharemarket. Sometimes Mr Market sets sensible share prices based on economic and business developments. At other times he is emotionally unstable, swinging from years of euphoria to years of pessimism. But Mr Market is also highly seductive – sucking investors (and forecasters) in during the good times with dreams of riches and spitting them out during the bad times when all hope seems lost. Trying to get a handle on all that and presenting it as a precise forecast or even as a grand market call is not easy.

While precise economic forecasts can be useful, particularly in communicating a view, investors need to recognise they have limitations. So if there is no easy way to predict the market, what should investors do? My view is that there are several rules worth following.

Rule No. 1 – Respect the market

It is well known that investment markets are not always rational. But, there are numerous examples of investors who came a cropper because they thought they were better than the market.

J.M. Keynes observed that “the market can stay irrational for longer than you can stay solvent”. In other words, you may even have a view that ultimately turns out to be right, but could end up losing a lot of money if you get the timing wrong.