Lets Accept it. We are not God

Predicting future returns of a risky investment. All of us want to do it. Many of us believe we can do it. But the truth is that none of us can predict future returns on a risky investment. In all humility Lets accept it, we are not God. If we knew the future and all that the future will give us, there would be no uncertainty and life would be completely predictable.

Everybody wants to predict

We are at a time of the year (Happy New Year!) where popular discussions revolve around what the new year, 2019, holds for us. Experts of all hues are busy predicting the interest rate for 2019, the SENSEX in 2019, the inflation rate in 2019, the gold price in 2019, the GDP in 2019, etc. These predictions are made with a aura of authority. The experts seemingly are telling you: Listen I am an expert, I have been in this line for so many years and I know the markets inside out. So I am saying that the SENSEX will touch 40,000 in 2019. (Just as a piece of information, when the stock market was booming in 2007, there were predictions that the SENSEX will touch 50,000 by the end of 2008!!!)

Common people, without the pretense of this aura, fall for it and actually believe that the experts are capable, through some God-given intellect, of being able to predict what 2019 will bring to them in terms of returns on risky investments. But is that what the theory of finance teaches us? Does the theory of finance teach us that we can predict future returns?

But What do the Founders of the Subject Have to Say?

Lets see what the real experts say on this subject.  The real experts are those who conduct scientific research not advice unsuspecting common persons. All the so-called financial experts we read and hear in our daily  lives have learnt from the experts who created the subjects such as Efficient Market Hypothesis, Investment Theory and Portfolio Theory. So let us go back to the real experts. As scientists they understand what their theories can explain and also the limitations of the prediction models they have developed. In this article we explore the thoughts of one such real expert.

Eugene Fama, a Nobel Prize winner in Economics for his theory on Efficient Market Hypothesis, which explains stock market behavior, had this to say about predicting the prices on stock markets (see https://www.newyorker.com/news/john-cassidy/interview-with-eugene-fama): I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.

The financial analysts who we read about in the media and who advice us on financial planning have learnt their subject from economists like Eugene Fama. So when Fama says the correctness of a prediction is only known in hindsight (and never in foresight), those who learnt the subject from his books and articles should also know the same.  But they take on a highly authoritative demeanor making all of us believe that we are financially illiterate.

Events Affecting the Market Prices Are Not Understood – They Cannot be Predicted

Fama makes a distinction between efficiency in the stock markets and events that are outside the stock market. We take two examples below.

Prices of goods and services in the economy

For example, a fall in the real estate prices is not related to efficiency of the stock markets but is an event outside the stock markets. Yet a fall in the real estate prices affects the stock markets in a big way. In 2007 leading to the stock market crash of 2008, real estate prices rose and rose and rose. No one could predict that they would crash in 2008. And when the markets crashed trillions of dollars of wealth was wiped out all over the world.

The behavior of firms in volatile markets

In the period leading to the market crash of 2008, the Volatility Index of stock prices was 60%. At 60 % Volatility Index, the correct thing for housing finance companies would have been to stop lending or at least be much more careful to whom they are lending to and for what period. But the lending boom continued and finally crashed.  Who could have predicted that the lending will continue in a big way with the Volatility index at 60 % ? Fama mentions that the behavior of the housing finance companies cannot be predicted – will they stop lending or will they continue to lend?

What does Fama say on this lending behavior of housing finance companies? It would be stupid for anybody to give credit (loans) in those circumstances (very high volatility), because the probability that any borrower is going to be gone (and not repay the loans) within a year is pretty high. In an efficient market, you would expect that debt would shorten up (i.e. the lending term would be shorter). Any new debt would be very short-term until that volatility went down. 

But in practice was it so? Did the housing finance companies stop lending? No under conditions of very high volatility, they lent more money and more money. It does not make sense. That is why Fama says, the behavior of firms under different market conditions cannot be predicted.

But Can we Predict Volatility? Or Do we even understand volatility?

When asked by the interviewer on what causes volatility? Fama replied: Again, its economic activity—the part we don’t understand. So the fact we don’t understand it means there’s a lot of uncertainty about how bad it really is. That creates all kinds of volatility in financial prices, and bonds are no longer a viable form of financing.

The markets are even now (10 years later) not fully recovered from that crash. And already there are some “experts” who are predicting another crash in the next one or two years.  From the guru of Stock Market Theory we learn that there are many reasons and causes that make risky investments risky and none of those reasons or causes can be known and much less predicted. And yet all financial experts offer predictions as if they are in possession of a vision that only they have. So just to put it on record in our Blog I am giving a few predictions below (Please do not take it as my endorsement of their predictions):

Sr. No.	Prediction By	GDP (for FY 2018-2019)	Inflation (calendar year 2019)	10-Yr GOI Bond yield	Sensex	Gold
1	A. Balasubramanium, CEO, Aditya Birla Sun Life	7.5%	3.5% to 4.25 %	7.25 % to 76.5 %	33,000 to 39,000	$1300 per ounce
2	B. Gopkumar, ED and CEO, Reliance Securities	7.3%	3.7%	7.6%	42,000 by Dec 2019	Rs. 33,000 / 10 grams
3	Lovaii Navlakhi, MD and CEO, International Money Matters	7.25%	3.75%	6.75%	39,800	Rs. 34,000 / 10 grams
4	Madan Sabnavis, Chief Economist, Care Ratings	7.4%	4.0%	7.2% to 7.4%	38,500 to 39,000	$ 1250 to $ 1300 per ounce
5	Shanti Ekambaram, President, Consumer Banking, Kotak Mahindra Bank	7.2%	3.9% to 4.1%	7% to 7.25%	10% higher than Dec 2018 SENSEX	$1275 per ounce

Calculations by finance experts

When finance experts use complicated mathematical models to predict the future, and publish their findings, it is a method of communication between one expert and another. It is not a communication between the expert and the layman.

There are many assumptions on which such predictions are made. Those without a knowledge of those assumptions or understanding the technicalities involved in arriving at the assumptions and the conclusions, should never be made a part of the discussions with exact figures of projections. It gives half information and is very misleading to the uninitiated. When projections of the type above appear in popular press, the uninitiated will assume that the SENSEX will touch at least 39,000 and base his or her investment decisions on that prediction. After all the experts are saying so and the layman is drawn to think that his investment decisions are backed by expert opinion. But as Fama said it is not for us to predict the many events that will shape 2019. There is as much a chance that the actual performance will be much more than the predicted 39,000 or much less than 39,000.

Today all the so-called experts while talking of investment risks in 2019 mention the following investment risks: global oil prices, Lok Sabha elections 2019, value of Indian Rupee and inflation. If risks can so easily be predicted, they are not risks, they are certainties. Certainties do not create market volatility. Risks do. What if the Chinese economy collapses? What if the European Union collapses? What if the real estate in India collapses? What if food prices continue to be very low and the farm sector purchasing power drops drastically? All these and many more that cannot even be imagined today are the risks of investing in risky investments.

Implications for the life insurance salesperson

Fortunately for us we do not have to deal with such complications and we do not have to hide the investment risks in our products. Traditional life insurance endowment is a wonderful product. Our role is to highlight the risks involved in all products. We sell risks. Not returns. When the risks of investing are explained in a scientific manner to the customer, the customer’s faith and trust on us improves significantly. Customers are more concerned about investment risks rather than returns. Explain to your customers the impossibility of predicting future returns on risky investments. It is like the three blind men trying to describe an elephant by feeling the elephant. We are not blind and we should not let our customers be blinded by the hype on mutual funds.

SELL RISKS NOT RETURNS

P.S. Please keep a copy of the Table above and see for yourself the actual figures for GDP, SENSEX, Inflation, etc. in 2019 and compare them with the predictions being made.