The document summarizes an article from Jim Parker discussing the difficulty of forecasting market movements and interest rate changes. It notes that 24 out of 27 economists incorrectly forecast that the Reserve Bank of Australia would cut interest rates, but it decided to keep them unchanged instead. This surprised markets and highlighted the inability of even experts to consistently predict economic decisions. The document advocates for long-term investing using diversification and discipline over reliance on forecasts.

1. OUTSIDE THE FL AGS
Jim Parker,
Vice President
DFA Australia Limited
Cracks in the Crystal Ball
FEBRUARY 2012
One of the mysteries of life in the financial markets is that many people
still seem to believe you can build a successful investment strategy around
forecasting, despite the road being littered with the corpses of those who
got it wrong.
This month, twenty-four out of twenty-seven market econo- markets puts an interest rate cut today as good as certain
mists polled by Bloomberg forecast that the Reserve Bank with weak retail sales figures indicating the worst growth
of Australia would cut its benchmark official cash rate by on record.”
one-quarter of a percentage point to 4.0%, the third such
move since November last year. Yet, the central bank confounded market expectations and
kept rates on hold. The market reaction was dramatic. The
The rationale seemed clear enough. The global economy Australian dollar took off like a rocket, hitting its highest
was moderating, local activity was slowing, household levels in six months against the US dollar and rising on the
spending had eased, employment growth was weakening, cross rates. Shares eased and bond yields rose.
inflation pressures had receded, and the strength of the local
currency was making life tough for non-commodity export- At this point, the very same economists who had carefully
ers and import-competing businesses. parsed the bank’s language going into its decision pro-
ceeded to analyze in great detail the wording of the state-
A Bloomberg journalist wrote: “The Reserve Bank of Aus- ment announcing that rates would stay where they were for
tralia is poised to respond to the nation’s weakest job market another month.
in almost 20 years by lowering interest rates for a third time
tomorrow, the most aggressive rate cuts since the global Actually, there really wasn’t that much remarkable about
financial crisis.” what the RBA said. Essentially, it had decided that, with
economic growth close to its long-term trend and inflation
In its own preview, the Sydney Morning Herald’s reporter on target, the RBA could afford to wait another month to
was even more emphatic: “A betting plunge on financial see how events in Europe and elsewhere panned out.

2. Local bank economists immediately pushed out their have a distinctive and unerring way of messing up your
expectations for the next policy easing to March. Some had impeccable logic.
second thoughts altogether and decided the central bank
might be done on interest rates for the foreseeable future. An example: In the US in February this year, strategists at
some of the world’s biggest investment banks capitulated
For everyday investors, there are a few lessons out of this on their bearish forecasts after global stocks registered
episode. The first is that there is very little evidence market their best start to a year since 1994. In a summary of recent
professionals—including the ones closest to policymakers— research, Bloomberg quoted strategists at several banks as
are any better than anyone else in forecasting the prices of admitting they had gotten their timing badly wrong.
securities, commodities, interest rates, or currencies.
The final message is that you don’t really need any of this
Last August, for instance, a global bond fund manager fundamental analysis to build long-term wealth. Markets
admitted he felt like “crying in his beer” over his call in are unpredictable because news is unpredictable.
March 2011 to dump almost all of his flagship fund’s US
government bond holdings because interest rates were This means the best approach is to structure a diversified
unsustainably low. portfolio that is built according to your own investment
goals and risk appetite, both across and within asset classes.
The second lesson is that trying to time markets—picking Occasional rebalancing of the portfolio ensures you main-
the turn in performance of bonds versus equities or govern- tain an asset allocation consistent with your risk profile.
ment bonds versus corporate bonds or value stocks versus The rest is all about discipline.
growth stocks—is a pretty tough job. In fact, few (if any)
people seem to get it consistently right. This may not be a particularly exciting investment story.
But it’s one that works. And it doesn’t require you to make
The third takeout is that it really doesn’t matter how strong forecasts about interest rates, currencies, stock prices, or
you think the fundamental case is for an interest rate economies. As we have seen, there are some serious cracks
change or a lower currency or a higher stock price; events in the crystal ball.
1. Michael Heath, “RBA Poised to Cut Rate on Worst Jobs Since ’92,” Bloomberg, February 6, 2012.
2. Peter Martin, “Markets Bet on Rates Cut,” Sydney Morning Herald, February 7, 2012.
3. David Magee, “PIMCO’s Bill Gross: Betting Against US Debt a Mistake,” International Business Times, August 30, 2011.
4. “Global Strategists are Abandoning Bearish Views,” Bloomberg, February 3, 2012.
‘‘Outside the Flags’’ began as a weekly web column on Dimensional Fund Advisors’ website in 2006.
The articles are designed to help fee-only advisors communicate with their clients about the principles
of good investment—working with markets, understanding risk and return, broadly diversifying
and focusing on elements within the investor’s control—including portfolio structure, fees, taxes and
discipline. Jim’s flags metaphor has been taken up and recognised by Australia’s corporate regulator in
its own investor education program.
Past performance is no guarantee of future results. Indices are not available for direct investment and do not reflect the
expenses associated with the management of an actual portfolio.
Diversification neither assures a profit nor guarantees against loss in a declining market.
Dimensional Fund Advisors LP (“Dimensional”) is an investment advisor registered with the Securities and
Exchange Commission.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is pro-
vided for informational purposes, and it is not to b construed as an offer, solicitation, recommendation or endorsement of
any particular security, products, or services.
©2012 Dimensional Fund Advisors LP. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting
of this material is prohibited.