The big business of prediction – Part One

Predicting where the stock market is heading has been the holy grail of financial professionals for over a century. Every year investment companies and forecasting firms dedicate enormous sums pitching their prognostications to investors, and it’s easy to understand why: the payoff can be huge. For brokerage houses and their sales representatives, it is a proven strategy for attracting uninformed investors looking to earn superior returns with minimal risk.

Unsurprisingly, the most ardent defenders of forecasting stock prices are those who make their living from it, including investment firms and financial news outlets. Most academic economists, on the other hand, are skeptical that any forecasting model—even the most sophisticated—can predict turning points in the markets. An overwhelming amount of evidence gathered over the last 80 years supports their position. A groundbreaking report titled Can Stock Market Forecasters Forecast? published in 1933 by Alfred Cowles III, an economist and founder of the Cowles Commission at Yale University, concluded, after thorough analysis, that it was “doubtful.” Since its publication, I am not aware of one credible report contradicting Cowles’ findings. Rather, several provide corroboration.

A 2012 study conducted by the Vanguard Group applied over a dozen different metrics (e.g. price to earnings ratios, dividend yield, etc.) to past stock returns for the period between 1935 and 2012. The goal was to identify reliable signals that might provide guidance for future performance. The researchers concluded that forecasting stock returns is essentially impossible in the short term. In other words, we simply have no way of predicting which way or by how much stocks will move over the next few days, weeks or months.  Furthermore, the researchers determined that even over longer time horizons of 10 years or more, many metrics assumed to have predictive value, in fact, had little to none.

In a 2015 article, Robert Shiller, Yale professor, and 2013 Nobel Laureate, wrote that after searching the news archives about the country’s major recessions beginning in 1920, he “found virtually no warning from economists of a severe crisis. Instead, the newspapers emphasized the views of business executives or politicians, who tended to be optimistic.” The almost-universally-unanticipated 2008 collapse of our country’s financial system offers a prime example. No model, including those developed at the world’s most elite institutions including the United States Federal Reserve Bank, foresaw a collapse until it occurred. Most were projecting continued GDP growth and rising asset values into 2009.

If we can guide rockets into outer space and back to earth with precision, why can’t some of the world’s smartest people using the most sophisticated technology develop reliable market forecasts? An explanation that has gained widespread acceptance is that current models are doomed to fail because they are vast simplifications of reality and cannot capture the interaction of forces that drive the markets. Instead, they rely on the conventional economic theory that assumes that the financial markets are made up of players who make decisions to buy and sell in a logical and predictable fashion. In 2000 and then again in 2008, investors worldwide witnessed firsthand the gap between theory and reality: in the real world, things get chaotic. When this happens, investors—swept up in the euphoria or panic of the moment—abandon logic and behave unpredictably.

In my next post, we’ll talk about a fundamentally new way of thinking about the financial markets.

Paying for college? What’s your plan?

Helping your children pay for college is one of the biggest and most important challenges that you will face. Currently, a four-year education (tuition, fees, room and board, supplies and personal expenses) can range from almost $100,000 at a public college to over $230,000 at some of the most expensive private institutions such as Boston University and The University of Chicago. With expenses expected to continue to rise at the current rate of 5% per year, the costs could skyrocket to $150,000 for a public college and over $360,000 for a private institution for a student matriculating in 2019. Making matters worse, planning for college gets more complicated each year because of the ever-changing rules, regulations and tax laws. Feeling overwhelmed and confused, many parents fail to develop an effective plan, leading to burdensome debt affecting both parents and students for years to come.

Studies have shown that while most parents feel helping their children pay for college is one of their most important financial objectives; few are financially prepared to do so. Some reasons include underestimating costs and failing to reduce discretionary spending to reach their college-funding goal. Some parents also have unrealistic expectations and make false assumptions regarding the availability of financial aid. Though in many cases parents and students will not be forced to bear the entire cost of the education, most college financial aid administrators agree that parents overestimate the amount of scholarship, grant and other financial aid their children will receive, and have a false sense of security that colleges will help them cover most expenses. Therefore, you should not base your college savings plan on the hope of a generous financial aid or scholarship package that may not come to fruition. The fact is about half of all college students get no such money at all, and instead have to pay the full price of college by borrowing, working, or withdrawing from their savings.

That, in essence, is the bad news. Now, here is the good news.

First, developing an effective college savings plan is achievable if you keep it simple and are willing to invest the time and effort to stay abreast of the changes in regulations and learn how to use the tax and investment options available to you. Tax-advantaged savings vehicles, as well as tax credits and deductions, are available to help take the sting out of college costs.

Second, for those of you who start saving early, you have time and the power of compounding on your side. Even small, regular contributions to a college savings plan can go a long way to defraying the costs of the time when your child starts college. Saving early and regularly is the surest way to build a college fund.

One of the most important things you can do as a parent is to help educate your children. Planning ahead, saving diligently, doing your research and applying some good old-fashioned common-sense will allow you to help your children pay for college when the time comes.

Estimating your retirement nest egg

For most Americans, retirement planning is ultimately focused on accumulating a “nest egg” of savings and investments to generate enough income to pay for a comfortable lifestyle.

To find out how large a nest egg you will need you must first estimate your “retirement income gap”. This is the difference between how much you’ll need each year to enjoy the lifestyle that you want and the amount of income that you expect to receive from sources including Social Security, employer pensions and part-time work. This gap will need to be filled from your personal savings and investments.

For example, using today’s dollars, let’s say you plan to retire at age 66 and determine you need $75,000 per year (before taxes) to enjoy a comfortable retirement. If you only receive $25,000 in income from Social Security, your investment portfolio will have to generate $50,000 every year after inflation for as long as you live. Using Social Security as the only income source simplifies the calculation because the benefits are automatically adjusted each year for inflation.

So how large a portfolio is necessary to generate $50,000 annually in inflation-adjusted dollars for as long as you live? Since running out of money is the number one concern for most retirees, much attention has been focused on this subject. The research has been directed specifically toward determining a “sustainable portfolio withdrawal rate”. This is the maximum amount that can be withdrawn from your retirement assets each year with reasonable confidence that the portfolio will provide a lasting income. Once you arrive at a withdrawal rate you are comfortable with, you can estimate the size of the portfolio required.

In 1994, Bill Bengen (a California financial planner) conducted a seminal study. His research suggested that based upon historical (1926-1975) inflation rates and investment returns, a retiree’s portfolio consisting of approximately 60 percent stocks and 40 percent bonds should, with a reasonably high probability, last for approximately 30 years. This was possible if an investor initially withdrew no more than 4 percent of the portfolio balance, and continued withdrawing that same inflation-adjusted dollar amount each year. Using this 4 percent guideline, if you determined that your retirement income gap was $50,000, you would need a portfolio of approximately $1,250,000 ($50,000 divided by .04) at the beginning of your retirement to fill that gap.

A caveat is in order here. While the 4 percent guideline can provide future retirees a target to shoot for, it is dependent upon several variables that differ from person to person and are impossible to predict with any accuracy. The best you can do is to make reasonable and conservative assumptions regarding how long you plan to live in retirement, what investment returns you expect to earn from your portfolio during retirement and what you expect inflation to be.

For those who want a high degree of confidence that they will not run out of money, it makes sense to be conservative about your future assumptions. Therefore, if you expect retirement to last longer than 30 years, or project future investment returns to be lower than historical returns, or anticipate future inflation to be higher than historical inflation, you should reduce your portfolio withdrawal rate below 4 percent. This means you will need a larger portfolio at retirement. Remember, the higher the withdrawal rate, the greater the chance the portfolio will not last as long as you need it to.