The Perils of Prognostication
It sounds silly to say that we can predict the future. Yet that's what most investors are actually doing. If you are actively picking stocks or mutual funds (everything but index funds), you are an active investor. For most investors, that means you have a view about the future.
An alternative course is to say that we don't know what specific companies or industries will work well in the future but we have confidence in the overall economy and the stock market. These "passive investors" use index funds or other low cost vehicles to cover all or large sections of the market.
To illustrate the difficulty of predicting the future, let me give two examples.
Central bankers are paid to assess an economy's direction and figure out what to do to help it perform better. I'm not saying that it is an easy task, but that's their full time job. They have access to all the information in the world and talented staff.
And what have they done lately?
In mid-summer, the European Central Bank actually raised interest rates. They were worried about inflation. Could happen to anyone. Except that worldwide we'd already been in a financial panic for a year. The U.S., the world's largest economy and Europe's key trading partner, was slowing down rapidly. It was clear to anyone that inflation was not the problem with one caveat: oil prices had climbed to a record $147 a barrel and nominal inflation statistics looked bad. Peering behind the headlines, it was obvious that these prices were not sustainable in an economic downturn and that they would drop if demand dropped and demand was dropping rapidly.
A second instance of a central bank misfiring. In August, U.S. Federal Reserve Governor Richard W. Fisher voted to increase rates.
At the September 16 meeting, the entire U.S. Fed voted to keep rates unchanged. This was one day after Lehman Brothers failed and Merrill Lynch did a forced merger, the day that AIG needed an $85 billion bailout and one day before Treasury unveiled a $700 billion bailout plan. Markets around the world expected a Fed ease. The only reason that could be used in support of this decision is that the Fed thought rates were so low that no further cut would be helpful. That argument was demolished in October when the Fed did lower rates. The September statement also argued that both growth and inflation were significant concerns. They absolutely got that wrong.
If central bankers can't predict the economic future, how is it that you can?
It sounds silly to say that we can predict the future. Yet that's what most investors are actually doing. If you are actively picking stocks or mutual funds (everything but index funds), you are an active investor. For most investors, that means you have a view about the future.
A few investors, deep value investors like Warren Buffet, look at the value of the assets of a company and see how the management has performed. If they can buy the assets cheaply enough, they believe they will do well. They claim to not need to make predictions. But even they must make some future judgments in valuing assets.
An alternative course is to say that we don't know what specific companies or industries will work well in the future but we have confidence in the overall economy and the stock market. These "passive investors" use index funds or other low cost vehicles to cover all or large sections of the market.
To illustrate the difficulty of predicting the future, let me give two examples.
Central bankers are paid to assess an economy's direction and figure out what to do to help it perform better. I'm not saying that it is an easy task, but that's their full time job. They have access to all the information in the world and talented staff.
And what have they done lately?
In mid-summer, the European Central Bank actually raised interest rates. They were worried about inflation. Could happen to anyone. Except that worldwide we'd already been in a financial panic for a year. The U.S., the world's largest economy and Europe's key trading partner, was slowing down rapidly. It was clear to anyone that inflation was not the problem with one caveat: oil prices had climbed to a record $147 a barrel and nominal inflation statistics looked bad. Peering behind the headlines, it was obvious that these prices were not sustainable in an economic downturn and that they would drop if demand dropped and demand was dropping rapidly.
A second instance of a central bank misfiring. In August, U.S. Federal Reserve Governor Richard W. Fisher voted to increase rates.
At the September 16 meeting, the entire U.S. Fed voted to keep rates unchanged. This was one day after Lehman Brothers failed and Merrill Lynch did a forced merger, the day that AIG needed an $85 billion bailout and one day before Treasury unveiled a $700 billion bailout plan. Markets around the world expected a Fed ease. The only reason that could be used in support of this decision is that the Fed thought rates were so low that no further cut would be helpful. That argument was demolished in October when the Fed did lower rates. The September statement also argued that both growth and inflation were significant concerns. They absolutely got that wrong.
If central bankers can't predict the economic future, how is it that you can?