Thirty-five years ago, in Back to the Future Part II, we were treated to a glimpse of a world where one man could predict the future.
A young High School student with an attitude problem, Biff, got hold of a sports almanac telling him every result for the coming decade. The results of this superpower were bad for Marty, creating a dystopian future where the wrong people ruled the world.
In the world of investment management nobody holds that magic almanac.
We do not know what the future will bring. But that does not stop many people pretending as if they do have it tucked away in their back pocket, creating vast tomes of research confidently predicting that this event or that event will drive markets in this or that direction.
Even the people who themselves decide the cost of money can’t tell us what they will decide in the future.The reality though is much less certain than pundits suggest. A major study by CXO group reviewed 6,584 market pundits over a seven-year period and found that their ability to be right was just 47% - slightly worse than flipping a coin.
The sum total of the predictions by the market as a whole is little better.
In an academic paper from He, Li and Zhou published this year, an attempt was made to establish whether the most rigorous surveys from institutions such as the Federal Bank of Philadelphia and the Federal Reserve Bank of Richmond, which asked market participants for their views, helped guide us to what would happen in the future. It found the same conclusion; it is no better than a random walk.
Perhaps more worryingly even the central banks which have the power to decide the future – setting the cost of money because of the decisions they make in their meetings – have a low rate of success.
The dot plot published by the Federal Reserve has been found to have a near 100% correlation to what happens to interest rates a month into the future, but by the time forecasts for a year’s time are tested the correlation to what actually happens falls to 0.75 and two years out it is less than 0.25.
Even the people who themselves decide the cost of money can’t tell us what they will decide in the future.
FOMC Median Projections vs Actual Rates 2017-2022
No surprise then that John Galbraith once wrote that ‘the only reason economic forecasting exists is to make astrology look respectable.’
There are lots of reasons we find predicting the future hard. Our brains are poor instruments for making assessments – tending to over-emphasise some more readily available risks over others.
We also tend to want to fit every problem into our own belief system, believing the market will follow our rules.
Once, when the two opposing economic giants of the 20th century, Fredrich Hayek and John Meynard Keynes, debated economic predictability together, Keynes posed the cheeky question to Hayek – who was ideologically opposed to over-spending – "are you telling me that if I buy a new overcoat tomorrow it will lead to higher unemployment in the future?".
Hayek quickly replied: "Yes, but it would require too long a mathematical equation to explain why". If there is a mathematical equation for predicting the future, we do not have it yet.
So how can we respond to this world of uncertainty when we try to build portfolios that can follow a predictable path? I believe we have a choice.
We can just join the pointless forecasting game and forecast, well, like there’s no tomorrow.
Or we can get real and ask how to practically increase the predictability of portfolios.
I believe the evidence shows that if we want more predictable behaviour from our investments that must come at a price, and that once we start investing, we must accept at least some level of short-term volatility.
An uncertain world does not allow us to have high guaranteed returns. However, it is possible to build more reliable long-term returns if we are willing to forego a really good outcome in exchange for a higher chance of an acceptable outcome.
Derivatives and defined returns
The derivative market enables us to buy contracts which will give us the long-term return of equities – between 7-8 per cent - over the next six years in all but the bleakest market scenarios.
However, accepting this return means that if the market returns more than this, an investor will not get it.
It also means that in the unlikely but possible event of a dreadful market return – for example the market falling by more than 35 per cent and not recovering any of its losses for six years – then investors will not get this fixed return but rather something similar to the return of the wider market.
Finally, it means accepting that the 7 per cent to 8 per cent return will not happen every year, but over the long-term it should even out to this level on an annualised basis in the absence of horrendous markets.
Advisers will be familiar with this offer from kick-out structured product plans.
But we call this type of investment a defined return investment and it can now be purchased in open-ended funds offering daily liquidity and gilts as collateral.
It is also possible to be somewhat 'predictable' about its short-term performance.The open-ended fund structure means that investors can see the movement of defined return investments each day and choose to buy and sell.
The investments do not rise in a straight line but investors can have confidence that because they are legal contracts, they do deliver provided their terms are met.
With this type of investment, it is also possible to be somewhat 'predictable' about its short-term performance, understanding that 'predictable' does not mean going up in a straight line, but doing something relative to the market that can be predicted.
Accepting defined outcomes means controlling our expectations but also offers us one of very few routes to secure a more predictable future in a highly uncertain world.
I believe that, when used effectively as part of a holistic financial plan, it can improve the ability of financial advisers to plan effectively for the long-term.
Tom May is manager of the Atlantic House Defined Returns Fund
