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The Forecasting Season

December 15, 2016

'Tis the season to make forecasts. As we approach the end of the year, newsroom staffing dwindles and editors look for space fillers to keep the readers happy. Yes, here come the investment "outlooks" again.

Each year at this time, the financial pages are filled with "investment outlooks" that tell us what we can expect to occur in the markets in the coming year and where the best bargains are. Starved of news, reporters usually find there is no shortage of experts willing to share their forecasts with a public primed to believe that sound investing is all about finding a reliable crystal ball. Of course, these features can be fun to read if you don't take them too seriously. And they become even more entertaining a year later.

During the rocky start for global shares in January 2016, one major investment bank issued a call to investors to "sell everything", warning of a deflationary crisis and a cataclysmic year on markets. "Sell everything except high quality bonds," the bank advised clients in a research note. "This is about return of capital, not return on capital. In a crowded hall, exit doors are small." The bank forecast a decline of up to 20% in major stock markets, a fall in world crude oil prices to as low as $16 a barrel with only high-quality government bonds showing a positive result for the year.

At the time of writing, with 2016 almost over, those forecasts look well wide of the mark. As at late November, the major US equity indices were all at record highs. The UK FTSE-100 recently hit record highs and Brent crude was near $50 a barrel. Yet if you had known in advance the news of the year you might have imagined different outcomes, with the results of the Brexit referendum and US election confounding many media and market pundits.

Another favoured media template around the turn of the year is to come up with a list of "hot stocks" for the coming 12 months.

For instance, one popular website last December announced its picks for 2016 —Sky City, Fisher & Paykel Healthcare, Contact Energy, Hallenstein Glasson and Infratil. Each company had a bright future the website said. While that may be true, these companies share prices were all down (between -16.6% and -1.48%) as at 8 December 2016. Meanwhile the NZX50 as a whole was up 8.9%.

The better-known NZ Herald broker picks shouted that the top companies for 2016 would be Ryman Healthcare, Infratil, Chrorus, Meridian, Airwork and Sky TV. Only one of these companies has performed better than the average to date and that is Airwork – due in large part to the mid-year takeover by a Chinese conglomerate.

Inevitably with these lists, some stocks will do well, while others will do poorly. Without seeking to denigrate the abilities of the forecasting brokers, it is a tough job to consistently outguess the market. It's even tougher when your picks come out of a media list that many other people are reading.

In any case, a small portfolio like this is likely to be unnecessarily concentrated and open to what's known as idiosyncratic risk—influences related to individual companies and sectors. For instance, another news outlet picked a UK-based financial services company as a possible "currency play" for 2016, saying it might benefit from the Australian dollar weakening against the British pound.

Well, that might have been a good idea at the time, but the AUD actually rose nearly 20% against the pound year-to-date, the appreciation accelerating after the UK's vote to leave the European Union.

So you can see that investing based on forecasts about individual companies is extremely difficult because you have to take into consideration so many moving parts and future events (that are by definition unexpected).

A better approach is to diversify as broadly as possible across stocks, sectors and countries so as to lessen the influence of any one company, sector or jurisdiction. Diversification is an antidote to avoidable risks like holding too few securities. It can also save you from missing opportunities. Neither list cited here included New Zealand Oil & Gas up 50% nor CBL up 56%. By broadly diversifying, you're taking the guesswork out of investing and saving yourself a whole lot of time scouring the investment pages for stock picks.

Most of all, you're more likely to have many happy returns.

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