To start off, allow me to put forward a scenario.
Robert lives in Montreal. He is an opera enthusiast who loves visiting museums and historical sites. When he was younger, he played chess and his favorite film was The Sound of Music.
In your opinion, what is more likely?
- A. Robert is a lawyer
- B. Robert is a violinist for the Montreal Symphonic Orchestra (MSO)
Relying solely on the description above, it is tempting to assume that Robert is a professional musician. However, from a statistical point of view, Robert is more likely to be a lawyer. According to Caroline Larouche, President of the Young Bar of Montreal, there are around 27,000 lawyers in Quebec, which is obviously more than the thirty MSO violinists.
When we evaluate the prospect of an event, we tend to neglect relevant information, such as its likelihood of occurrence. This is called "neglecting sample size". Since this crucial step requires concentration, we prefer a quick analysis of the facts when making a decision, which can lead to poor judgment.
This phenomenon certainly exists in the field of investing. For example, when we anticipate the future direction of the stock market, we place a high value on our opinion, sensationalistic headlines, and commentaries from economists and financial analysts. Although this collection of information may be useful, it is preferable, initially, to base our reasoning on statistical data.
Exercise: How will the S&P 500 perform in 2017?
In keeping with the above logic, the first step is to consider relevant historical data for some background. In this case, the issue is long-term performance of the US index, the impact of a new US President has on the market, and the likelihood of positive annual returns given the feeble risk of a recession in the United States.
- Since 1928, the S&P 500 has averaged an annual return of 7.5%.
- Between 1945 and 2015, the S&P 500 generated an average annual return of 7.6% in the first year of a new presidential cycle.
- According to an analysis model used by the US Federal Reserve, the risk of recession in the US in 2017 is 4%, which is good news for investors. In fact, over the past 50 years, the S&P 500 has increased almost 90% of the time apart from economic downturns.
In principle, the S&P 500 should provide a return of around 8%. The next step is to use a rigorous information retrieval and selection process that is consistent with your management style and which can alter the performance assumption of the previous step. For example, in my view, Donald Trump's ambitious economic program, with its promises of expansionist budgetary stimulus (increased infrastructure and military spending) and fiscal stimulus (tax cuts for individuals and businesses) will be very beneficial for markets in 2017. I therefore believe that the S&P 500 can offer another year of outstanding performance of 15% to 20%. Regardless of your opinion about my forecast, my goal is to make you aware of the importance of being suspicious of your first impression and take a step back in order to make the right choices.