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The Value of Interest Rate Forecasts

As bad as the evidence is on active equity managers being able to outperform appropriate benchmarks on a risk-adjusted basis, the evidence is much worse for active bond managers. One reason for their failure is the inability to forecast interest rates more accurately than the market itself. The following tale is just another example of why there are only three types of interest rate forecasters:
  • Those that don't know where rates are going.
  • Those that don't know they don't know.
  • Those that know they don't know but get paid lots of money to pretend they do.
A year ago, The Wall Street Journal asked 50 economic forecasters for their prediction of where the yield on the 10-year Treasury note would be in one year. Forty-three expected the 10-year U.S. Treasury note yield to move higher over the year ahead, with an average estimate of 4.13 percent. Seven expected a rate of 5 percent or higher, while only two predicted rates to fall below 3 percent. The result? The 10-year Treasury yield slumped to 2.95 percent on June 30, 2010.

While the forecasts clearly turned out to be wrong, it doesn't mean the experts were incompetent. The point is that even the most talented analysts are unlikely to make reliable predictions. You shouldn't focus on endeavors that are likely to prove unproductive at best and counterproductive (because of the time and expenses incurred in the effort) at worst. Instead, focus your efforts on the things you can control:

  • The amount of risk you take
  • How well you diversify your risks
  • Costs
  • Tax efficiency
As Philip Tetlock noted in his book Expert Political Judgment, the most confident forecasters have worse records than less confident forecasters. Remember this the next time you're tempted to try and time the market based on the confident forecast of some economist or "talking head." The best strategy is to diversify reinvestment risk and inflation risk by building laddered portfolios and then staying the course.

For further reading on the failure of active bond managers: