Market Predictions Can be Harmful to Your Wealth

Here is why you should ignore 2012 stock market predictions.

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This is the time of the year when self-appointed investment gurus make predictions about the direction of the stock market and tell us which stocks to buy or sell in the coming year. Many investors follow these recommendations and often pay the price for doing so.

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Some of those making these predictions have stellar credentials. Jeremy Siegel is an excellent example. He is a Wharton professor of finance, the author of Stocks for the Long Run, and a senior adviser for WisdomTree Investments. In a previous blog I questioned Siegel’s predictive abilities. I noted that, at the end of 2007, he predicted that "the economy will avoid a recession" in 2008. His crystal ball also revealed that "the stock market will have another winning year in 2008" and that "financial stocks, which have plummeted 18 percent so far this year, will outperform the S&P 500 index next year [2008] as the credit crises fades."

The S&P 500 lost 38.49 percent in 2008, its worst year since 1937. Financials underperformed all market sectors, losing 56.95 percent.

Professor Siegel is not alone in his belief that he can predict the future with more accuracy than you would expect from random chance. CXO Advisory Group tracked the market forecasts of investment experts for two years. It looked at 5,000 measurements of more than 60 gurus. It found the overall accuracy of the group based on both raw forecast count and on the average of forecaster accuracies (weighting each individual equally) was 48 percent —which is about what you would expect from tossing a coin. In 1975, Nobel laureate William Sharpe found that a market timer who switches between 100 percent stocks and 100 percent Treasury bills annually would have to be right on average about 74 percent of the time to successfully beat the market.

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CXO took a hard look at the best known stock predictor, Jim Cramer, whose stock picks are followed avidly by many loyal viewers of his long running program, Mad Money. Researchers analyzed 152 “buy” and 108 “sell” recommendations made in July and August, 2005. They found that Cramer’s buy recommendations “likely encourage market underperformance”. Even worse, they concluded that his “sell” recommendations in the aggregate “may outperform the market after six months.” Cramer took issue with this analysis, resulting in an informative exchange which you can find here.

Investors seem to have a short memory. On December 28, 2010, Cramer confidently predicted the Dow would “hit 13,365 next year” [2011]. His prediction was “based on a prognostication of the performance of the individual members of the venerable index.” He justified this lofty prediction by giving individual stock predictions for the components of the Dow, which added up to the 13,365 for the index.

At the close of business on November 23, 2011, the Dow was at 11,257. While Cramer may quarrel with the analysis done by CXO, it would be difficult to dispute the irrefutable fact that his prediction for the Dow in 2011 is likely to fall far short of the mark.

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You would be well advised to ignore the onslaught of year-end predictions. If a guru turns out to be correct with a prediction, it is most likely attributable to luck and not skill. Intelligent investing does not rely on those who think they have the ability to peer into the future and predict tomorrow’s news. But these experts do have a skill. It’s persuading you to entrust them with your money, by touting a skill than does not exist.

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.

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