Asset allocation planning: Skip the ‘expert’ forecasts

By Seth Hammer, CPA, Ph.D.

As clients come in for their annual tax return preparation, an important concern for many may be whether they should reallocate their portfolio of investment assets. A key issue for clients and their advisors, however, is whether asset allocations, in addition to being revised based on factors such as changing goals and sensitivity to risk, should also be revised on the basis of “expert” predictions of future economic conditions.

Probably the first issue to consider in addressing this concern is whether, in fact, “experts” can accurately predict future financial market conditions. In a very prominent example – “expert” forecasts of Dow Jones Industrials’ performance, contained in Business Week’s annual investing issue – the answer seems to be a resounding “no.” Our research found no correlation between the consensus market forecasts and actual Dow Jones Industrials’ closing results (actual correlation, according to our research, for the period 1996-2004 was -0.09). Certainly, some individual “experts” did better (and some did worse), but it may be problematic to determine to what extent individuals perform better due to chance or to skill.

A second issue to consider, after recognizing that “expert” forecasting performance has been unsatisfactory in the past, is whether it might be realistic to conclude that “expert” performances could, nonetheless, improve sufficiently in the future to provide value to the individual investor. While future performance increases are certainly possible, such changes would seem highly unlikely because of experts’ demonstrated inability to adjust their forecasts in accordance with the great variability of the markets. An example of this variability is the Dow’s 20-year performance from 1985 to 2004, when the approximate average annual return was an impressive 12.5 percent, but in only three of the 20 years were actual returns within a 15-percentage-point range of 5 to 20 percent. An example of the shortfall of “experts” is the case of the Business Week experts’ forecasts for Dow closings for the period 1996 – 2004. We found that while the standard deviation for the actual changes during this period was 16.7 percent, the consensus experts’ standard deviation was only 5.1 percent.

The final issue for some practitioners may be whether acting upon the forecasts is any more likely to do harm than good. If one concludes that “expert” predictions are essentially equivalent to random chance, would not asset allocation revisions based on “expert” forecasts have just as much probability of increasing as decreasing the value of a portfolio? In the case of adjusting one’s portfolio to reduce stocks and increase bonds, the answer again would seem to be negative. Since stocks, historically, have outperformed intermediate government bonds and U.S. treasury bills approximately two-thirds of the time (from 1926 to 2004, stocks outperformed intermediate government bonds 65 percent of the time and U.S. treasury bills 63 percent of the time), an asset allocation of shifting stocks to bonds provides a very real risk that the market-timing strategy will result in a lost opportunity to achieve the historically higher return of stocks. Our research found, based on historical returns of 70 years (1926-2004) and 35 years (1970-2004), that “experts” would have to perform at a level of approximately 18 to 21 percent above random simply to match a non-adjusting (buy-and-hold) strategy. Factoring in potential tax consequences (e.g., loss of preferred tax rates and loss of compounding benefits) would require that “experts” achieve even higher results.

Conclusion

Certainly, practitioners can expect that some clients will not be immune from the lure of the latest hot “expert” predictions, whether arising through television, magazine or other medium. Practitioners may, however, serve to counter the potential damage of media-induced “buzz” and safeguard their clients by 1) providing their clients with the appropriate factual information and 2) continuing to focus on developing appropriate client-centered asset allocation strategies (e.g., development of a risk-adjusted diversified portfolio).

Seth Hammer, CPA, Ph.D., is an associate professor of accounting at Towson University and the author of CCH's “Investments and Taxes: A Practical Guide for Financial Advisers” (June 2004, second edition). His articles have appeared in “Tax Advisor,” “The Journal of Retirement Planning” and other journals. He is a member of the MACPA’s Personal Financial Planning Committee.

Contact this Author: < Seth Hammer > shammer@towson.edu

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