This chapter would not be complete without poking a little fun at my colleagues (and at myself by association!), the financial economists. Economists are frequently employed to make economic and stock market predictions for prestigious financial institutions. Economists are highly trained in economic theory and statistics. Does this education give them an advantage in forecasting that can help other investors? This section examines the predictive behavior of practitioner and scholarly financial economists.
Many economists are employed by Wall Street firms and are asked to make stock market direction predictions. Every June and December, since 1952, Joseph Livingston has surveyed economists from business, the government, and academia. About 40 economists forecast the level of S&P 500 Index both 7 and 13 months ahead. This is known as the Livingston survey. The survey originated as a product of the newspaper, the Philadelphia Enquirer, but became so highly regarded that it was taken over by the Federal Reserve Bank of Philadelphia. How do these highly regarded economists do?
By comparing their S&P 500 Index prediction to the index level at the time they made their prediction, they can compute the return they are predicting for the market over the next 7 and 13 months. Werner De Bondt examined these predictions over the period from 1952 to 1986 and compared them with the actual S&P 500 returns.20 The astonishing finding is that the economists in the Livingston survey show no predictive power whatsoever. The predictions were totally unrelated to the realized returns.
Another interesting analysis was conducted to examine the economists' predictions after large market moves. For example, what were the predictions after big bull markets or big bear markets? In general, economists predict reversals in the market after big moves, but they are a bit pessimistic about it. The study examined the predictions after the 10 best market periods in the sample and after the 10 worst periods in the sample. For example, after experiencing a large bull market over the previous two years, economists predicted that the next seven months would see a 5.53% return. By predicting a negative return, the economists were clearly stating that the stock market overreacts. The actual seven-month return after the bull markets was 6.44%. Thus, the economists underpredicted the actual performance by nearly 12%. After two years in a bear market, the economists, on average, predicted a seven-month return of 6.02%. The actual average return on the market was 15.09%. Thus, the economists again underpredicted the actual returnthis time, by 9%.
The 19th-century historian Thomas Carlyle dubbed economics as the "dismal science."21 After reading this, you may agree!
Another study showed that economists could suffer from the same psychological biases as anyone. In this study, academic financial economists were asked for their predictions about the future return on the stock market. This question was a little different from the Livingston survey question. Specifically, the scholars were asked about the average market risk premium over the following 30 years. The risk premium is the difference between the return in the stock market and the return for low-risk fixed income securities like Treasury Bills. For example, if the market return was 12% and T-Bills earned 4%, then the risk premium was 8%. The risk premium is important because it determines the reward the investor should receive for taking risk. In theory, this risk premium helps to determine effective asset allocations for investors.
Ivo Welch, a Yale University financial economist, administered the first survey in late 1997 and throughout 1998.22 Note that this survey was conducted after a long bull market was underway. The economists had seen some high market returns in the period just before taking the survey. Several behavioral biases should be noted.
The 226 financial economists that responded to the survey predicted an average annual market risk premium of 7.1%. They also predicted that the consensus among their colleagues would be 7.6%. Two points should be noted. First, for most economists, the prediction they made was near the consensus target they offered. This indicates that the economists used their belief about a consensus to anchor their own beliefs (see anchoring in Chapter 2). Also, it is interesting to note that the economists liked to predict a risk premium that was different (albeit similar) to their consensus estimate. Why did they think that their estimate was better than the consensus of their peers? Believing your predictions are more accurate than others' is a characteristic of overconfidence (see Chapter 2).
Professor Welch surveyed his colleagues (and mine) again in 2001.23 This survey followed a severe stock market downturn. There were 510 economists that responded to the second survey. The average 30-year risk premium prediction in the second survey was 5.5%. Note how dramatically lower this estimate was compared to the 7.1% prediction in the first survey. It appears that the short-term upward trend in the stock market before the first survey made economists optimistic about the next 30 years, while the short-term downward trend before the second survey made them pessimistic about the next 30 years. This extrapolation of trends was discussed as a representative bias in Chapter 2.
The results of these studies suggest that both practitioner and academic financial economists appear to be affected by their psychological biases.