Most of Wall Street and the financial media are about creating noise -- noise that gets the attention of the investor. Wall Street is about noise, because every time you act,
generates profits -- whether you do or not. As Eddie Murphy's character in
noted, in that way brokers are like bookies. Likewise, the media need you to pay attention to the noise, because that is how they make money -- getting you to tune in.
The media are often filled with headlines like "Sell Stocks Now." And there are always risks about which investors "should" be worried. At various times the headlines scream about the risks of inflation, recession, oil prices, natural gas prices, the Middle East, terrorism, trade deficits, budget deficits, etc. While it may be very hard for you to ignore advice that comes from a prominent and intelligent sounding spokesperson -- one who has also provided what seems like a very cogent argument -- that is exactly what you should do.
The latest noise about risk to put a scare into the hearts, minds and stomachs of investors is the threat of deflation and the damage that it can do to corporate balance sheets and profits. The risks became even more highlighted when
Chairman Alan Greenspan noted that the issue has his attention. Let's see why one of the greatest mistakes investors make is to confuse the noise created by the markets and the media with information that is valuable to them and thus should be acted upon. We begin by examining the ability of economists or other gurus to forecast accurately.
What Economists Know
William Sherden was inspired by the following incident to write his book
The Fortune Sellers
. In 1985, when preparing testimony as an expert witness, he analyzed the track records of inflation projections by different forecasting methods. He then compared those forecasts with what is called the "naive" forecast -- simply projecting today's inflation rate into the future. He was surprised to learn that the simple naive forecast proved to be the most accurate, beating the forecasts of the most prestigious economic forecasting firms equipped with their Ph.D.s from leading universities and thousand-equation computer models.
Sherden reviewed the leading research on forecasting accuracy from 1979 to 1995 and covering forecasts made from 1970 to 1995. His conclusions:
Economists cannot predict the turning points in the economy.
He found that of the 48 predictions made by economists, 46 missed the turning points.
Economists' forecasting skill is about as good as guessing.
Even the economists who directly or indirectly run the economy -- the Federal Reserve, the Council of Economic Advisors and the Congressional Budget Office -- had forecasting records that were worse than pure chance.
There are no economic forecasters who consistently lead the pack in forecasting accuracy.
There are no economic ideologies that produce superior forecasts.
Increased sophistication provides no improvement in forecasting accuracy.
Consensus forecasts do not improve accuracy.
Forecasts may be affected by psychological bias.
Some economists are perpetually optimistic and others perpetually pessimistic.
Economist and Nobel laureate Paul Samuelson observed: "I don't believe we're converging on ever-improving forecasting accuracy. It's almost as if there is a Heisenberg
Uncertainty Principle." Michael Evans, founder of Chase Econometrics, confessed: "The problem with macro
economic forecasting is that no one can do it." And this is from the head of a firm that makes its living selling such forecasts.
Because the underlying basis of most stock market forecasts is an economic forecast, the evidence suggests that stock market strategists who predict bull and bear markets will have no greater success than the economists.
What the Market Knows
There is another important point to make about the current concern over the risk of deflation. One of the benefits of the introduction of Treasury Inflation Protected Securities in 1997 is that investors have an instrument that provides them with a good estimate of the
forecast of inflation.
To get an estimate for a specific period, subtract the real yield on TIPS from the nominal yield on a similar-term nominal coupon Treasury instrument. At midyear 2003, a TIPS with a maturity of July 2012 was yielding about 1.8%. With a Treasury bond of similar maturity yielding about 3.4%, we observe that the market's forecast is that we will experience inflation of about 1.6% over the next nine years.
Clearly, the Federal Reserve is concerned about deflation and has already taken aggressive action to help prevent it.
The market is fully aware of this, and perhaps that is why it is forecasting inflation, not deflation. The important point is that if the market is aware of information, that information is already incorporated into prices, and thus it is too late for investors to benefit from the information -- unless you believe that somehow the market has misinterpreted that information and thus mispriced securities. And there is no evidence that even professional investors can persistently benefit from so-called market inefficiencies or mispricings.
Further, deflation itself is not necessarily a bad thing. The perfect example is that we have experienced a very long period of deflation in the computer industry. Despite this deflation, both investors and society have benefited greatly. It is only deflation of financial assets (e.g., stocks, real estate) that should cause concern.
What Investors Need to Know
Not every individual is affected in the same way by inflation or deflation. For example, debtors (typically younger investors who have mortgage debt, for example) actually benefit from inflation, as the real cost of their debt falls and their earned income will generally at least keep up with inflation. On the other hand, retirees living on a fixed income suffer from inflation. The reverse is true of deflation, as the real cost of debt rises and the cost of living falls. Thus it is important to understand how each person is affected by a particular risk.
And because none of us has a clear crystal ball, the time to address the risk is before the fact, not when the risk actually appears on the horizon. In other words, the risks of inflation, deflation, recession, terrorism, etc., are always present -- and we never know which one will show up when. Thus all risks should be incorporated into the planning process, when the investment policy statement and the all-important asset allocation decisions are made.
Investors need to understand how risks are likely to affect them personally. For example, the impact of a recession on the earned income of a tenured professor, civil servant or health care professional is likely to be far less damaging then it might be for a worker engaged in a cyclical industry. As we have already discussed, in general, retirees should be much more concerned about inflation, while there are others who should be much more concerned about deflation. Investors for whom inflation is the greater risk should probably avoid longer-term fixed-income instruments (because of the negative impact on inflation), investing instead in shorter-term instruments and inflation-protected securities.
Investors for whom deflation (and the potential for an accompanying recession) is the greater risk should consider purchasing longer-term fixed-income instruments. Similarly, individuals who have greater concerns about their earned income being at risk in recessions should consider a lower equity allocation than individuals who have a high level of job security. Similarly, because the asset classes of small, value and real estate have greater economic cycle risks than do large growth stocks, investors with less job security should consider owning less of the riskier asset classes. On the other hand, investors with greater job security can consider a greater allocation to the riskier asset classes.
Since we cannot foresee the future, the prudent and rational approach to investing is to assess all the risks and how they are likely to affect you personally, before you make any investment decisions. All of the risks should be thought through very carefully, keeping in mind that each action you take to reduce one type of risk has an offsetting reaction. For example, if you have a low level of job security, it might be prudent to have a low equity exposure.
However, eliminating or reducing equity risk also means lowering the expected return. Hedging the risks of deflation by purchasing longer-term securities increases the risks of inflation -- and vice versa. Thus it is important to understand which risks pose the greatest threat to your financial goals, and then incorporate that concern into your asset allocation decision-making process.
Investors should never make the mistake of treating even the highly unlikely as impossible, nor the highly likely as certain. Consider all risks when building a well-diversified portfolio. For example, it is virtually certain that very few (if any) Japanese investors in 1990 had built into their financial plans the potential for either a drop of over 75% in the Nikkei index or sharp and persistent deflation. In other words, investors should not consider the risk of deflation (or a bear market) simply because the media is currently highlighting that particular risk. Instead, that risk should be considered before making any investments, and the risk should be incorporated into the investment policy statement.
Finally, risks should never be considered in isolation. Instead, because some risks can be hedged, or at least reduced, consider the risk of the entire portfolio, and not the risk of each asset class in isolation. For example, investors attracted by the higher current yields of longer-term bonds might be tempted to go further out on the yield curve. By increasing the maturity of their fixed-income investments, they have reduced the risk of deflation. However, they have increased the risk of inflation. This increased risk can be offset to at least some degree by increasing the allocations within the equity portion of the portfolio to the asset classes of value and real estate. Companies in both of these asset classes are typically highly leveraged, and because inflation reduces the real cost of debt, these asset classes tend to outperform growth stocks in periods of inflation. Of course, they also tend to perform poorly in periods of deflation and/or deflationary recessions -- however, that is exactly when we would expect the longer-term bonds to perform well. Thus the offsetting risks provide somewhat of a hedge.
Investing involves risks that are always present. The investment process should be all about the management of risk and expected reward, not about trying to forecast a future that is unknowable. Thus the time to be concerned about risk is at the very beginning of the investment process -- not when the media or some investment guru begins to discuss the latest risk about which investors should worry. A well-thought-out and well-designed plan is the best way to ensure that investors stay disciplined and do not allow the noise of the market, and the emotions that are fueled by the noise, to cause their well-thought-out plan to end up in the trash heap.
Forewarned is forearmed.
Larry Swedroe is the author of "
What Wall Street Doesn't Want You to Know," "
The Only Guide To A Winning Investment Strategy You Will Ever Need ," "
Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today ," and the soon-to-be-released "Successful Investing Today: 14 Simple Truths You Must Know." Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services. TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.