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Enter the Dragon 2012

August 4, 2012 1 comment

This article was first published in B Beyond 2012/1 (page 88) by BB Publications – a niche publisher catering for the global HNW and UHNW community. http://bbpublications.org/

The S&P 500 index ended 2011 relatively unchanged despite a year of high volatility driven by the European Sovereign Debt Crisis and the pertinent risk of double dip recession. During the year, the markets witnessed the major impacts of the Arab Spring, the Japanese earthquake, the downgrading of the US credit rating and the risk of a Eurozone country defaulting on its debt obligations – none of which were ‘predicted’ by Wall Street analysts at the beginning of the year.

The future is much harder to predict than Wall Street would have us believe. As Nassim Taleb remarked: “To prophesize, don’t add anything to the future; just figure out and eliminate what will not survive.” This Popperian view, that all investment hypotheses are provisionally accepted until proven wrong, may not seem comforting to investors.  Nonetheless, it has not stopped the influx of money flowing into hedge funds.

Hedge funds on average lost 4.83% in 2011 despite amassing a record $2.04 trillion in total capital under management during the first quarter of 2011. The industry – which caters to wealthy and institutional investors chasing higher returns for bigger fees – appears to be licking its wounds as fund managers finished the year in the red. The hedge fund industry – which prides itself on outperforming the market – has failed to live up to expectations and delivered one of their worst annual performances last year. As 2012 – the year of the Water Dragon according to Chinese Zodiac – rolls on, can the industry reverse its fortune?

Renewed optimism in Europe’s ability to solve its debt problems and the U.S. economic recovery has led analysts to expect a brighter 2012 with hedge funds gearing up on riskier bets. The question then remains: Why are the so-called ‘Wall Street analysts’ invariably wrong?

Despite their relatively poor record in making financial predictions, it seems to be a staple publication for analysts each year. From a non-deterministic worldview, the future is unpredictable; therefore, a successful investment manager should be able to change his views as events that either confirm or refute his investment hypothesis unfold. Making a public prognostication in the form of a financial prediction begins a very slippery slope towards intellectual materialism. Subsequently changing one’s view would be tantamount to admitting that the former was, in fact, erroneous. Making erroneous financial calls reflects badly on an investment manager. This agency problem may manifest itself when the manager seeks out confirmatory evidence for his earlier thesis and subconsciously filters out contradictory evidence. Such intellectual materialism is a highway to financial ruins. Perhaps money managers should refrain from making explicit public commentary on financial markets for this very reason. It frees them from the shackles of having to defend their views and allows an unfettered approach towards investing. This separation is exemplified further in the financial service industry’s highly regulated relationship with its research divisions, requiring a Chinese wall between public and private functions.

So then, why are analysts’ predictions invariably wrong? To borrow from quantum physics’ Totalitarian Principle which states “everything not forbidden is compulsory” – it is not possible to envisage or even model the future states of all permissible events that can occur and affect the markets. This is akin to the adage commonly referred to as Murphy’s Law that is typically stated: “anything that can go wrong will go wrong”. The job of a money manager is therefore not just to react to such events but to be perceptive. George Soros famously remarked that “it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong”. As the collective action of investors translates to the ebb and flow of the financial markets, the investment manager’s job is to remain one step ahead of the crowd. There is no point in being right one year in advance as the financial markets can remain irrational longer than one can remain solvent.

The hedge fund industry’s performance for 2011 is an egregious example of ‘smart money’ getting it wrong. The industry as a whole underperformed the broader market. This is an industry that hires the best and the brightest minds armed with MBAs and often wielding PhDs from the top business schools in the world. Compensation in this industry is second to none. Hedge funds understood what politicians have long understood – that there is no shame in buying success. The industry goes to great length to justify its compensation and management fees. Can this be one of the reasons as to why the asset management industry continues to churn out financial predications, the majority of which are often not worth the paper they are printed on? After all, the industry that pours millions into its research departments ought to be seen as making informed investment decisions based on well-researched ideas. A simple flick through previous years’ financial predictions and their propensity to come to pass will reveal dismal statistics. Nonetheless, the media’s deep-seated fascination for financial predications continues to contribute to the proliferation of analyst recommendations aimed at investors.

Ask any economist or analyst how precise their estimates are, their response will be that such predictions help guide decision-making in investments more satisfactorily than it would be otherwise. That however inaccurately or irresponsibly their predictions may help shape investment decision, it does so better than astrology. However mindless the culture of prophesying, it is more attractive than disremembering. And however deceptive the idea of an analyst’s estimate, it is more believable than that of a coin toss.

As for my financial predictions for 2012, it will take a leaf out of Chinese astrology. The year of the Water Dragon may bring more economic trouble in the year ahead. According to Chinese Feng Shui, the economy is very much affected by the five elements in Chinese astrology (wood, fire, earth, metal and water). In the Chinese calendar, the fire element will generate optimism and happiness. Therefore, if the financial market represents the collective optimism of investors, it should rally with the fire element.  The water element is the opposite and it represents fear in the five-element system. Happy 2012 – the year of the Water Dragon!

 

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Categories: Economics, Finance, Investing Tags: , ,
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