The Folly of Stock Market Forecasting

This post simultaneously appeared at AlphaArchitect.com

The idea that one can predict stock market movements is somewhat insane.

The major problem with stock market forecasting is the lack of evidence that it is possible. I am unaware of any market commentator that has been successful–on a consistent basis–at predicting the future direction of the market. Certainly, every once in a while a pundit or luminary may get something right, but it doesn’t occur often enough by the same party to demonstrate any significant level of skill. Throw enough darts at the dartboard, and your bound to hit a bulls-eye sooner or later. (For a humorous look at the track record of various pundits I suggest a piece by Michael Johnston for fundreference.com1)

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Berkshire Hathaway As An Asset Class?

Admit it, if you’re using some sort of asset allocation strategy this question has crossed your mind. I’m not talking about indirectly owning Berkshire through a fund*, but a direct concentrated holding of the stock itself. Aside from having one of the greatest investors of all time run your money there are some additional fringe benefits. At the very least it gets you a ticket to the shareholder meeting held in Omaha every spring. Dilly bars anyone? Many have written about various pros and cons of Buffett’s businesses. The shareholder letters are publicly available to anyone who wants to read. But how has Berkshire performed as an asset in the context of an overall portfolio?

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Linchpin

Over the past few years I’ve found myself having a recurring conversation with friends, colleagues and family members. Despite indications that the economy is healthy and moving along, it sure doesn’t feel that way, and it’s tough to identify exactly why. Consider the following US economic data from the end of 1999 through 2014

1999 2014 Annualized
Change
Median Household Income $57,843 $53,657 -0.5%
Real After Tax Corp. Profits $523.1B (Q4) $1,700B (Q4) 6.2%
Real Gross Domestic Product $12,323.3B (Q4) $16,151.4B (Q4) 2.0%
CPI (Inflation) 168.3 (Dec) 234.812 (Dec) 2.4%
Effective Federal Funds Rate 5.30% (Dec) 0.12% (Dec)
Source: Federal Reserve Economic Data (See Below)

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The Factors Of Returns

The idea of exposing an investment portfolio to various “factors” (i.e. small company stocks, value stocks, etc.) as a means to improve returns has been around for decades. The value premium traces its roots back to the mid-twentieth century with the work of Benjamin Graham. Warren Buffett, a student of Graham, used value investing early on in his career to help build his fortune. Research on the size premium (small company stocks outperforming large company stocks) goes back to early 1980s and the work of Rolf Banz. [1]

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The Black Swan

I consider myself a child of the Global Financial Crisis (a.k.a. The Great Recession). As I wrote about in my introduction I started my career in early 2008, just as the US housing market was unwinding and shortly before financial markets imploded. To those not familiar with financial markets this sort of event would appear to be a rarity–a one-in-a-billion (I’m embellishing) sort of event. Looking back at financial history, however, paints a very different picture. Severe market movements, both positive and negative, have occurred with greater frequency than I (or most others) realize.

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The Mythical Rebalancing Bonus-Part 2

In Part 1 I showed that as investment time increased there was, at least historically, a smaller probability of realizing a rebalancing bonus in 60/40 stock/bond portfolios. There was a lot that I left unaddressed at the time and I felt a need to develop a better understanding of the mechanics of the rebalancing bonus. Why does it work in some instances, but not in others? In other words, more was needed to demonstrate what actually drives the rebalancing bonus. A good place to start is with the work of Harry Markowitz, which showed that portfolio performance–both return and volatility–was mathematically related to three characteristics of the constituent assets

  1. Correlation with other assets
  2. Volatility
  3. Rate of return

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The Mythical Rebalancing Bonus-Part 1

Go to part 2

The rebalancing exercise that I performed with Shannon’s Demon implied that a premium may be obtained by rebalancing a portfolio of uncorrelated assets. These assets featured highly hypothetical performance with expected rates of return and volatility both well out-of-bounds of anything that’s likely to be seen in real world capital markets. The extreme nature of these make-believe stocks was used to illustrate what is possible.

Back to reality.

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