Why You Should Ignore Market Experts
Market experts should be viewed as a source of entertainment rather than reliable financial advice.[1]
- People often crave certainty, even when it may lead to wrong decisions. This is illustrated with an example of choosing a doctor who seems certain about a diagnosis.[1:1]
- Financial Markets and Certainty: In the world of financial markets, certainty rarely exists. Market experts often claim to have insights that can guide investment decisions, but their reliability is questionable.[1:2]
- Actively Managed Funds: Evidence shows that actively managed funds, where market experts try to outsmart the market, consistently fail to outperform their benchmark index.[1:3]
Studies on Market Experts’ Predictions
- A study by CXO Advisory Group analyzed 68 stock market experts’ forecasts from 2005 to 2012, finding an aggregate accuracy of less than 50%.[1:4]
- The Guru Dex study assessed the stock predictions of large institutions for a 12-month period ending in December 2015, showing an average stock prediction accuracy of 43%.[1:5]
- Institutions Included in the Studies: Big names like RBC Capital Markets, Goldman Sachs, and UBS were included, with only four of the 16 institutions having greater than 50% accuracy.[1:6]
- Investor Returns Based on Predictions: If an investor had acted on the stock predictions of these large institutions in 2015, they would have earned a negative 4.79%, while the S&P 500 was relatively flat at minus 0.69%.[1:7]
- Motivations Behind Forecasts: Market experts may have motives other than accuracy, such as attracting attention to their institution or publication.[1:8]
- Notable Market Expert Mistakes: Andrew Roberts of the Royal Bank of Scotland made headlines in early 2016 by advising investors to “sell everything” for a “cataclysmic year,” but 2016 and 2017 were excellent years for investors.
- Warren Buffett’s View: Buffett has expressed skepticism about short-term market forecasts, comparing stock forecasters unfavorably to fortune tellers.
The Importance of Skepticism
- Despite the temptation to listen to market experts, the data refutes their ability to improve investment decisions.
Lack of Regulation for Market Experts
- There is no licensing body or minimum level of education to become a market expert, and no level of education or intelligence makes it possible to consistently beat the market.
- The video emphasizes the importance of skepticism towards market experts and their predictions, highlighting the lack of evidence supporting their ability to consistently make accurate forecasts. It encourages viewers to approach such advice with caution and to recognize the potential motivations behind these predictions.
How much risk should you take?
Risk is central to investing, with the potential for financial gain and loss. Risk means a distribution of outcomes, and it’s beyond our ability to predict or control. However, we can choose the type and amount of risk in our investments.[2]
Two Types of Risk
Idiosyncratic Risk
Also known as company-specific or diversifiable risk, it’s not related to the market as a whole. It can result in substantial losses but can be diversified away. Example: Volkswagen’s share price drop after the emissions scandal.[2:1]
Market Risk
This is the risk of the market as a whole and cannot be diversified away. Investors expect a positive long-term return for taking on market risk.[2:2]
Diversifying Idiosyncratic Risk
Owning all stocks in the market eliminates specific risks of each company, leaving only market risk. This means owning a globally diversified portfolio of index funds.[2:3]
Equity and Bond Mix
Most investors have a mix of equity index funds and bond index funds. Stocks have outperformed bonds historically, while bonds have been less volatile. A portfolio becomes less risky with a higher allocation to bonds.[2:4]
Decision on Risk Taking
The decision about how much risk to take is driven by the ability, willingness, and need to take risk.[2:5]
- Ability to Take Risk: Driven by time horizon and human capital. Younger people with more earning capacity can take more risk.
- Willingness to Take Risk: Some investors may find market risk too volatile for their preferences. Comfort with potential declines is essential.
- Need to Take Risk: Related to goals, such as retirement spending. Most people need to introduce some level of risk to increase expected returns.
Handling Risk in Portfolio
The right amount of market risk is sufficient to meet the goal without introducing the potential for catastrophic failure. Rules of thumb exist, but there’s no optimal answer. Investors add bonds to match their ability, willingness, and need to take risk.[2:6]
Investors should approach risk based on their individual circumstances and goals. Understanding and consciously choosing the level of risk in an investment portfolio should be emphasized.[2:7]
Asset Allocation
Understanding the importance of asset allocation in investment and the main asset classes.
Asset allocation is the exercise of determining how much of each asset class you should hold in your portfolio. The main asset classes include stocks, bonds, real estate investment trusts, and alternatives.[3]
Total stock market exposure is a given in asset allocation. The mix between stocks and bonds is subjective, and exposure to factors is important but often overlooked.
Capital Asset Pricing Model (CAPM)
Introduction to the Capital Asset Pricing Model and its role in quantifying risk and returns.
The CAPM quantifies the relationship between risk and expected returns. It sees risk and return as being determined by a portfolio’s exposure to market beta.
Global Exposure
Importance of diversifying across Canadian, US, International Developed, and Emerging Markets stocks.
Combining Canadian, US, International Developed, and Emerging Markets stocks into a portfolio improves the risk and return characteristics. The optimal mix is unknown, making the geographic asset allocation choice mostly arbitrary.[3:1]
Canadian Stocks Bias
Tax Treatment is the reason for a bias toward Canadian stocks in many portfolios.
Many portfolios have a heavy bias toward Canadian stocks due to tax treatment.
Bonds
Bonds are less risky than stocks and have lower expected returns. Adding Canadian bonds to the portfolio can reduce risk without significantly reducing returns.[3:2]
Real Estate Investment Trusts (REITs)
The role of bonds and real estate investment trusts in reducing risk and potentially increasing returns.
Adding a small allocation to REITs can increase historical annualized return while lowering standard deviation.[3:3]
Avoiding Alternatives
Reasons for avoiding certain alternative investments.
Avoid alternative investments like hedge funds, managed futures, preferred shares, and high yield bonds due to unfavorable characteristics.[3:4]
Fama-French Three-Factor Model
This model relates expected returns to exposure to the market, exposure to small stocks, and exposure to value stocks. It explains about 90% of the difference in returns between diversified portfolios.[3:5]
Factor Exposure
The significance of factor exposure in portfolio construction, including the Fama-French Three-Factor Model.
Adding exposure to factors like market beta, size, value, and profitability can be beneficial. However, obtaining factor exposure can be challenging.[3:6]
REITs Revisited
Recent research shows that the return of REITs is explained by market beta, size, and value factors, so a portfolio with exposure to these factors may not need an allocation to REITs.
How to Evaluate Your Financial Decisions
Investment decisions cannot be evaluated based on their outcomes. It emphasizes the difference between a good decision and a good outcome, especially in the context of uncertainty.[4]
The importance of making investment decisions based on specific risks and goals, and judging decisions on the quality of the process rather than the outcome.
Uncertainty in Investments
Uncertainty is an inherent part of any investment, and what can be controlled is the quality of the investment decisions.[4:1]
Evaluating Decisions
Understanding the risk, the reason for taking it, and the expected outcome is crucial.[4:2]
Decision Evaluation Process
Evaluating investment decisions at the time they are made, understanding the risks, reasons, and expected outcomes.
The importance of evaluating a decision at the time it is made, rather than when the outcome is known, is stressed.[4:3]
Investment Decisions vs. Outcomes
Understanding that a good decision may lead to a bad outcome and vice versa, especially in the context of uncertainty.
Market Risk Premium
The video explains the concept of the market risk premium and how it has been a reliable aspect of investing historically.[4:4]
Short-Term Evaluation Challenges
The challenges of evaluating investment decisions in the short term are discussed, including the fact that stocks can trail bills over 10-year periods.[4:5]
Challenges in Short-Term Evaluation: Acknowledging the difficulties in evaluating investment decisions in the short term.
Luck and Outcomes
The role of luck in investment outcomes is explored, with examples of how different retirees can have vastly different outcomes based on market timing.[4:6]
Role of Luck
Examining how luck can influence investment outcomes and the importance of persistent risk premiums.
Risk Premiums and Value Stocks
The reliability of long-term risk premiums is discussed, along with the example of U.S. value stocks and their performance over the past decade.[4:7]
Market Risk Premium: Recognizing the historical reliability of the market risk premium.
Value Stocks vs. Growth Stocks
U.S. value stocks beat growth stocks by 3.3% per year from 1928 through 2018. In Canada, value beat growth by 2.59% per year from 1977 through 2018, and in international developed markets, value beat growth by 5.01% from 1975 through 2018.[4:8]
Individual Stocks
The challenges of owning individual stocks are highlighted, emphasizing that picking individual stocks is generally a losing bet.[4:9]
Active Funds
The performance of active funds is examined, with data showing that top-performing funds often do not remain in the top quartile over time.[4:10]
Diversification
The importance of diversification across geographic regions and risk factors is emphasized. Diversification is shown to reduce the impact of uncertainty and increase the chances of achieving expected outcomes.[4:11]
Bayesian Thinking
The concept of Bayesian thinking is introduced, explaining how it can be applied to investment decisions by weighing new information against prior assessments.[4:12]