Admitting Ignorance

May 10, 2011
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“After more than a quarter-century as a professional economist, I have a confession to make: There is a lot I don’t know about the economy.” – N. Gregory Mankiw.

The well-kept secret that the media won’t tell you is that, in spite of the fact that they do it all the time, economists find making predictions fairly tough, and they’re really not very good at them

I’ve commented on this before, and past posts are grouped under the Series: The Cloudy Crystal Ball.

If You Have the Answers, Tell Me

In this Sunday’s New York Times column, Harvard professor and economist N. Gregory Mankiw admits with some humility what he doesn’t know.  And he doesn’t know a lot, apparently.  That list includes the very things we care and worry about as consumers, investors, Americans; things such as the future direction of the U.S. economy and unemployment, the future amount and impact of inflation on consumer spending and business investment, and how long the U.S. government will be able to borrow money at such low interest rates.

How refreshing for a professional economist to be humble.

Professor Mankiw’s column is brief and well worth reading.

He concludes with this, “If you find an economist who says he knows the answers, listen carefully, but be skeptical of everything you hear.”

Larry Swedroe has, for many years, expressed similar skepticism about the ability of forecasting to add value.  Mr. Swedroe is director of research for The Buckingham Family of Financial Services, author of several books that I have read with great pleasure, and he is my absolute favorite blogger at Wise Investing.

Never In Doubt, Often Wrong

Here is something he said in 2002.

The track record of economists is dismal (perhaps that is the real reason it is called the dismal science). The track record of market strategists is equally dismal. Despite this, the press and media focus on forecasts (though rarely holding the forecasters accountable, for accountability would end the game) and investors pay great attention to them; allowing the forecasts to influence or even determine their investment strategy.

Buckingham’s Swedroe on Housing, Oil, Investing

In a recent interview aired on Bloomberg TV, which is well worth viewing in my opinion, Swedroe said emphatically, “There are no good forecasters.”

Not merely offering a criticism of forecasters and prognosticators, he also discusses the “right way” to invest.  Specifically, Mr. Swedroe advises controlling risk by widely diversifying, keeping costs down and keeping taxes low.  And, of course, by not buying actively-managed mutual funds. 

Amen.

Comments

5 Responses to “Admitting Ignorance”

  1. Bud Kraus on May 10th, 2011 7:53 am

    My father would love this post, because he has no idea what economists do other than make forecasts that are wrong more often than not. And there never are any consequences to economists getting it wrong. Reminds me of meteorologists.

  2. Matthew Raden on May 10th, 2011 11:21 pm

    He makes some valid points. However, not buying actively managed mutual funds is an overreaction. Even if you accept the thesis that Index funds generally outperform actively managed funds, this does not mean that you shouldn’t buy ANY of the latter. Rather, it is an issue of portfolio allocation. It means you should buy MORE Index funds than actively managed ones.

  3. Roger on May 10th, 2011 11:45 pm

    Matthew,

    If you buy an actively-managed mutual fund, it might outperform an index fund, but the odds are against you. Just how would you go about selecting an actively-managed fund that you think will outperform an index fund? Are you making a theoretical argument or a practical one?

    Roger

  4. Gary Emanuel on May 11th, 2011 11:01 pm

    Some actively managed funds consistently do or did better than their indexes over long periods of time. No guarantee they can continue to do so and granted they may be few and far between. What is your rebuttal against owning Magellan Fund, for example in the past as long as Peter Lynch was at the helm? I am not saying bet the farm but why not “diversify” with some well chosen funds that have a long term track record (5-10+ years of outperforming) as long as the same manager stays on the job?

  5. Roger on May 12th, 2011 12:35 am

    Gary,

    It sure would be great if we could identify in advance which mutual fund manager will outperform the relevant benchmark. Looking back, it is easy to identify winners. Looking forward it is not at all easy.

    Actually, the evidence is that it cannot be done. When I say evidence, I refer to studies of pension funds, university endowments, mutual funds and individual investors. THERE IS NO STATISTICAL EVIDENCE OF THE PERSISTENCE OF SUPERIOR INVESTING PERFORMANCE. NONE.

    As you say, there are precious few managers who have outperformed for 5-10 years. So just when do jump on board. After 5 years? 6 years? 7? And if that manager disappoints you, when do you abandon ship?

    Following a “hot hand” manager will typically result in a very poor return. Why? In addition to the possibility that the good results were actually luck masquerading as skill, there is the problem of “asset bloat.” You and many others will all be plowing money into the winning fund, thus ballooning the amount the manager must deploy. If he or she has 3 or 4 really good ideas per year, investing $500 million is much easier than investing $3 billion. A really successful manager will likely become a “closet indexer.” But you’ll be paying a lot more in management fees for the pleasure of following a winner.

    For a description of the performance of the Magellan Fund after Peter Lynch, see this article.

    http://www.wassermanwealth.com/default.asp?S=638281

    The conclusion is

    “If the legendary Fidelity Magellan manager, who had access to the top talent and could train them himself, cannot produce the next great fund managers, why should ordinary investors believe they can pick them?”

    Now if you are researching and choosing active mutual fund managers as a lark, have fun. If you are doing it to try to increase your risk adjusted returns, you are surely playing the loser’s game. It’s similar to drawing to an inside straight in poker, which I am sure you know is not a good strategy.

    Roger