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How accurate are those annual market forecasts?

Market strategists predict the S&P 500 index will rise 10.5 percent in 2012. That's according to a recent USA Today article by Adam Shell. Adding in a 2 percent dividend yield, that translates to a 12.5 percent return for the most commonly used benchmark of U.S. stock performance.

But how accurate are these forecasts? Well, Adam Shell interviewed strategists a year earlier who predicted the S&P 500 index would increase by 9.4 percent in 2011. In fact, the most pessimistic of these strategists predicted that the market would rise only 5 percent. With just three trading days left in 2011, the S&P 500 is up only 0.6 percent, not including dividends. For all the ups and downs investors suffered through this year, the market has essentially gone nowhere. 

These strategists clearly missed the mark, but not by as much as Goldman Sachs (GS), which predicted a gain of nearly 25 percent for the S&P 500 in 2011, according to CNBC. (Goldman Sachs, however, fared better in its predictions of rising gold and oil prices.) And although Goldman Sachs' stock lost about 45 percent of its value in 2011, I didn't see any prediction made there.

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I asked USA today reporter, Adam Shell, for his thoughts on his annual article on predictions. "Wall Street crystal-ball gazing is more art than science," he said. "Right or wrong, it grabs attention."

Are economists better?

Predicting stock returns is never easy, but it turns out predicting interest rates may be even harder. On May 5 of this year, Wells Fargo chief economist,John Silvia, proclaimed interest rates would definitely rise for the remainder of 2011. When I asked him for specifics, he stated that rates on five- and 10-year Treasurys would increase by 0.3 to 0.5 of a percentage point by year end. Instead, rates on the five-year Treasury declined by a staggering 0.96 percentage point, while the 10-year Treasury declined by 1.22 percentage points.

When questioned about his definitive forecast, Silvia responded the rate decrease was due to a "downshift in economic growth expectations and continued problems in Europe." Silvia is not alone among economists with malfunctioning crystal balls. He is one of the 60 economists interviewed semi-annually by The Wall Street Journal who have correctly called the direction of interest rates just 35 percent of the time -- or less accurately than a coin flip, according to a study by Bianco Research.

The one economist who got it all right

Virtually no one predicted the financial meltdown of 2008. One economist, Gary Schilling, made 13 gloomy predictions for 2008 and was right on every single one. Was it luck or skill? It turned out that he made 13 gloomy predictions for 2009 and was wrong on every one. An investor who discovered him in 2009, and then embraced his predictions for that year, would have made radical changes to his portfolio and missed out on a great rebound.

Prediction addiction

The data are compelling that financial forecasts are typically very inaccurate. But Adam Shell is right when he says they grab our attention. In his book, Your Money and Your Brain, Jason Zweig observes that people hate randomness. As the author says: "The human compulsion to make predictions about the unpredictable originates in the dopamine centers of our reflexive (emotional) brain." That's why these predictions grab our attention.

Zweig notes that when presented with almost any data, your investing brain will feel like it knows what's coming -- and it will usually be wrong. The next time you see a prediction, even one with compelling logic, you may want to ratchet down your confidence in that forecast, and ask yourself how much you will lose if that brilliant prognostication is wrong.

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