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Why Most Wall Street
Analysts Are
Wrong
A group of investors with whom I
occasionally meet recently posed a question
to me concerning the forecasts that are
regularly made by economists, investment
strategists, and equity research analysts
regarding the economic and financial market
forecasts that are regularly made by the
so-called Wall Street “experts.”
After answering their question, I
thought, “Hmm, many of our readers have
probably had that same question since the
time they began investing in the financial
markets.”
That question was, “Why are the
so-called Wall Street experts almost always
wrong?”
Many years ago, I also wondered why such
(supposedly) well-trained, knowledgeable,
and experienced professionals tend to be
wrong much more often than they are right,
about the direction of the economy, the
overall financial markets, and individual
security prices.
In this article, I discuss my answers
to that question.
My experience suggests that there are
four primary reasons why the Wall Street
“experts” are almost always wrong:
- Most Wall
Street experts fall prey to the
phenomenon known as groupthink
- The
research span of most Wall Street
experts is very limited
- Most Wall
Street experts lack creativity and have
a limited knowledge base
- Most Wall
Street experts seem to be much more
concerned about their own financial
well-being than the investment
performance results of their clients
GROUPTHINK
One of the major reasons that the so-called
“experts” almost always are wrong has to do
with the phenomenon of groupthink.
Groupthink is a type of thought exhibited
by members of a group who try to minimize
conflict and reach consensus without
critically testing, analyzing, and
evaluating different ideas. As a result of
groupthink, most Wall Street analysts, money
managers, and investment strategists tend to
be unconcerned that their forecasts are
wrong as long as most of their peers are
also wrong. In other words, those so-called
“experts” feel vindicated as long as most of
their peers made similar forecasts,
regardless of the inaccuracy of those
forecasts. Those same experts tend to excuse
their poor forecasts by making statements
such as “nobody saw this coming” or
“everyone expected. . . such-and-such to
happen.”
A good example of this type of groupthink
behavior was demonstrated during late 2007
and early 2008, when most economists and
investment strategists told the world that
economic conditions in both the United
States and most other regions of the world
were in sound shape, that the housing market
was undergoing a short-term “correction,”
and that stock prices in general would
continue to trend higher during the ensuing
months.
After later evidence proved that those
forecasts were wrong, most of the so-called
Wall Street experts responded in typical
fashion by either failing to comment on the
prior forecasts or by saying, “Nobody saw
this coming.”
As an example, a former employer of mine
said on a nationally broadcast news program
during early 2009 that anyone who didn’t
lose a lot of money during 2008 simply got
lucky. Of course that supposed “expert”
would make such a claim — the mutual fund he
manages lost more than 35 percent of its
value during 2008.
LIMITED RESEARCH SPANS
The second reason that the Wall Street
experts’ forecasts tend to be wrong much
more often than they are right is because
the research span of most Wall Street
analysts tends to be limited. For example,
the majority of Wall Street brokerage firms
and investment banking firms, as well as
most large mutual funds, tend to be
structured in a way that prevents actual
experts from different fields of study at
those entities from sharing and discussing
their independent analyses and forecasts.
For example, economists, investment
strategists, and individual security
analysts employed by the larger Wall Street
brokerage and investment banking firms, as
well as by most large mutual fund companies,
rarely meet to discuss their independent
analyses and forecasts.
Instead, any given firm’s staff of
economists tends to meet with other
economists, investment strategists meet with
other strategists, and individual securities
analysts meet with other securities
analysts.
As a result of that flawed structure,
groupthink emerges in each of those
respective areas of expertise, and the
so-called experts in each of those fields
tend to focus on their individual areas of
“expertise” without taking into
consideration factors outside of their realm
of knowledge that might affect the direction
of the economy, the financial markets in
general, or the prices of individual
securities.
CREATIVITY AND KNOWLEDGE BASE
The third reason that most of the so-called
Wall Street experts usually are wrong is
that investment analysts in general tend to
lack creativity and to have a limited
knowledge base.
Rather than thinking “outside of the
box,” most Wall Street economists,
investment strategists, and securities
analysts tend to be textbook regurgitators —
they analyze the economy, the overall
financial markets, or individual securities,
and then make forecasts concerning those
subjects that are consistent with what they
learned in college or from some other
credentialed field of study. However, few
Wall Street analysts explore possibilities
beyond what they learned from those fields
of study.
A good example of this common pitfall is
securities analysts’ use of the
price-to-earnings (P/E) ratio when they
analyze the supposed soundness of investing
in a particular stock. For example, many
securities analysts would claim that a stock
that has a P/E ratio of, say, 50 is
overvalued and that such a stock should not
be considered for investment. Likewise,
those same analysts would claim that a stock
that had a P/E ratio of only 10 was
undervalued and that the stock should be
purchased. In contrast, I would argue that
the stock that has a P/E ratio of 50 is
undervalued if its underlying company was
expected to double its earnings during each
of the next three years. Likewise, I would
argue that the stock that has a P/E ratio of
10 was overvalued if its underlying company
was expected to grow its earnings at a rate
of only 5 percent during each of the next
three years.
In addition to lacking creativity, most
Wall Street analysts tend to be
knowledgeable in only a limited number of
subjects. For example, most securities
analysts tend to have a solid foundation in
analyzing corporate financial statements but
to be completely inept in using technical
analysis to determine the most opportune
time when to purchase or sell any given
stock.
Likewise, some portfolio managers tend to
be trained very well in ways to identify
stocks whose prices often rise sharply
during most environments. However, if those
managers lack a solid training in economics,
they might purchase such a stock even when
certain economic developments suggest that
the stock will decline sharply during the
ensuing months.
I was presented with an example of this
situation during February 1994, when the
senior portfolio manager at the firm that I
was employed at that time had just began to
aggressively purchase stocks for a
small-cap, growth fund that he managed. When
I asked that portfolio manager to explain
the reasons that he had begun to buy stocks
aggressively at a time when numerous
economic statistics suggested that stocks
would pull back sharply within the ensuing
weeks, he said, “I’m not an economist.” My
unspoken response was, “Well, you need to be
one.” (By the way, the value of that fund
fell more than 4 percent between Feb. 1 and
March 31, 1994, as stock prices in general
did, in fact, pull back sharply during that
period.)
PERSONAL-VS.-CLIENT FINANCIAL WELL-BEING
The last, but least acceptable, reason that
most Wall Street analysts tend to be wrong
much more often than they are right about
the direction of the economy, the overall
financial markets, and individual security
prices is that the actions of many of those
so-called experts suggest that they are much
more concerned about their own financial
well-being than the financial well-being of
their clients.
A good example to support that claim is
the fact that the vast majority of
investment advisers and equity mutual fund
managers tend to allocate almost 100 percent
of their funds under management to equity
securities even during periods when an
overwhelming amount of evidence indicates
that stock prices will fall sharply. Instead
of allocating a large portion of a fund’s
assets to cash-like securities during such
environments, those so-called experts tend
to invest a larger portion of their funds
under management to so-called “defensive
stocks” — to stocks that tend to depreciate
less than most other stocks when stock
prices in general fall sharply but
nonetheless still tend to decline in value
when stock prices in general fall sharply.
There’s a very good reason as to why
investment advisers or mutual fund managers
might make that type of decision: Their
income tends to be based on the amount of
assets under management for the funds that
they advise/manage. In the event that the
amount of assets under management were to
decline, the advisers’/managers’ incomes
would decline.
Those advisers/managers recognize that
there’s a higher probability that many of
their clients will terminate their advisory
contract or liquidate their holdings from a
given fund if a large portion of their
assets are allocated to cash. That’s because
those clients would realize that they were
paying an adviser/manager to do something
that they easily could do for themselves.
Meanwhile, securities analysts are
largely unaffected by their poor investment
recommendations. That’s because
institutional investors rarely rely on a
securities analyst’s investment
recommendations. Instead, they tend to use
securities analysts’ reports for
informational purposes. Secondly, most
securities analysts never meet the
individual investors who invest in their
securities recommendations. As a result of
those factors, the incomes of securities
analysts are almost completely unrelated to
the investment recommendations. Hence, even
if the price of a stock that a securities
analyst recommends falls sharply, that
analyst’s job will not be in jeopardy.
In closing, you now should have a much
better understanding as to why most of the
so-called Wall Street experts almost always
are wrong — why most economists, investment
strategists, and equity research analysts
tend to be wrong much more often than they
are right about the direction of the
economy, the overall financial markets, and
individual security prices.
You also might want to consider seriously
whether you should continue to follow the
advice of those so-called “experts” or
whether you should seek some other sources
when determining when and how much of your
hard-earned money you should invest in the
financial markets.
Sincerely,
David Frazier
Editor, Your Million Dollar Secret Code
Member of Newsmax’s Financial Brain Trust
P.S. — We have placed this article along
with more important information on our
website
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