Predicting the Market and Setting An Annual Return Target

We all want to know what happens next

One of the most natural things for an investor to do at the beginning of every year is to look ahead and ask a very simple question: where will the market be by the end of the year?

We want to know whether the STI will rise, whether Hong Kong stocks will finally recover, whether the US market can continue its rally, whether interest rates will fall or rise, and whether China will eventually return to stronger economic growth. Once we have made our market forecast, it is quite natural to go one step further and set a target for our own portfolio.

Perhaps we tell ourselves that we should make 10 percent this year, 15 percent next year, or maybe even 20 percent if we are feeling more optimistic.

There is nothing wrong with having expectations, and I do not think investors should completely stop thinking about the future. The problem begins when we start believing that the future can be predicted with much more accuracy than it actually can.

After many years of investing, I have become much more comfortable with admitting that I simply do not know what the market will do in any particular year. That is also why Uncle does not set a yearly return target for his portfolio.

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Mr Market Is Not a Machine

One of the most important things I have learned about investing is that Mr Market is not a machine that follows a predictable set of rules. We often treat the market as though it is a complicated mathematical equation, where if we collect enough information and build a sufficiently sophisticated model, we should eventually be able to predict what happens next. I am increasingly convinced that this is the wrong way to look at it.

The market is better understood as a complex adaptive system, where millions of investors, institutions, companies, algorithms and governments are constantly reacting to new information and, more importantly, reacting to one another. As new information enters the system, people change their expectations, their behaviour changes, prices move, and those price movements then create new information for other participants to react to.

This creates continuous feedback loops.

A rising share price can make investors more confident, which encourages more buying and pushes the price even higher. At the same time, falling prices can create fear, which leads to more selling and causes prices to fall further. Eventually, the behaviour of investors becomes part of the event itself.

This is why markets can sometimes behave in ways that appear irrational when viewed from a distance.

The interesting thing is that the market is constantly adapting. Every new piece of information changes the behaviour of some participants, but their reaction then changes the environment for everyone else. Once that happens, the original conditions are no longer exactly the same.

This makes the market inherently difficult to predict.

The Butterfly Effect in the Market

This is where the idea of the butterfly effect becomes interesting.

The basic idea is that a very small change in one part of a complex system can eventually contribute to a much larger outcome somewhere else. It does not mean that every small event will cause a major event, but rather that we cannot always know which small event will eventually become important.

Take something outside the stock market. Imagine a small delay at an airport caused by bad weather. One aircraft arrives late, which delays the next flight, which means some passengers miss their connecting flights. Those passengers then take alternative flights, which affects the number of available seats elsewhere, while another aircraft and its crew are also moved around to deal with the disruption. What started as a relatively small delay at one airport can eventually affect hundreds of flights and thousands of passengers across an entire network.

The financial market can behave in a similar way.

A relatively small piece of unexpected news may initially have little impact. But if it changes the expectations of enough people, their behaviour begins to change. Businesses may postpone investments, consumers may become more cautious, companies may revise their plans, and investors may reassess their expectations. Those reactions then create new information, which causes other participants to react again.

The original event may have been insignificant, but the feedback created something much larger.

This is one reason why financial markets can occasionally produce what we call Black Swan events, where the eventual outcome is far outside what most people expected.

We often assume that the biggest market events must have had an obvious cause from the beginning. In reality, the chain of events can be much more complicated , from a small event with cascading effect turns to bigger and much serious problem.

For investors, I think the lesson is quite simple. We should be careful about believing that we can forecast every major market movement simply by analysing today's information. In a complex and constantly adapting system, tomorrow's outcome can depend on interactions that we cannot see today.

That does not make investing impossible.

It simply means we should respect uncertainty.

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Why This Makes Mr Market So Erratic

This is also why I find it difficult to take precise market forecasts too seriously.

When millions of participants are constantly learning, adapting and reacting to one another, the market is not simply responding to information. It is continuously changing because of the reactions to that information.

That creates a moving target.

By the time we have analysed the economy, studied the historical patterns and built our forecast, the market itself may already have changed because other participants have received different information and reacted differently.

This does not mean analysis is useless. Far from it.

We still need to understand businesses, valuations, earnings, cash flow, debt and the broader economic environment. The difference is that we should recognize the limitations of our analysis.

Analysis can help us make better decisions. It cannot remove uncertainty.

For me, this is another reason why I prefer to build a portfolio that can withstand uncertainty rather than one that depends on my ability to predict it.

Mr Market will continue to behave erratically because that is simply part of his nature. He adapts, reacts, overreacts and occasionally surprises everyone.

Our job is not to tame Mr Market.

Our job is to understand that we never really know what he is going to do next, and make sure that our portfolio is strong enough to live with that uncertainty.

The market is much less predictable than we think

If markets behaved like a machine, predicting annual returns would probably be much easier. We could study economic growth, interest rates, company earnings, valuations and other factors, put them into a model, and calculate what the market should be worth at the end of the year.

Unfortunately, the real world does not work that way.

There are simply too many things happening at the same time, and many of these things interact with one another in ways that are difficult to anticipate. A small event that initially appears insignificant can sometimes develop into something much larger, while another event that looks serious may eventually have very little impact.

This is one of the ideas I took away from the interesting examples involving turkeys, camels, dams and sandpiles. They are different examples, but they all illustrate a similar point, cause and effect are not always proportional, and systems can sometimes behave very differently once they reach a certain point.

A turkey can be fed every day for 1000 days and become increasingly confident that tomorrow will be just like today. A camel can carry one more straw without any obvious consequence, until eventually another straw becomes the one that causes the load to become unbearable. A dam can hold an enormous amount of water for a long time, even as pressure continues to build, and then a relatively small change can suddenly lead to a much bigger consequence. A sandpile can also grow grain by grain, with most grains causing almost nothing to happen, until eventually one additional grain causes a much larger collapse.

Markets behave in similar ways.

We often assume that if something small happens, the market should have a small reaction, and if something big happens, the market should have a big reaction. In reality, the relationship is rarely that straightforward.

Sometimes an important piece of news barely moves the market, while something that initially looks relatively minor can trigger a much bigger change in sentiment.

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We are always better at explaining the past

This is also why market predictions often look much more impressive after the event than before it.

Once something has happened, we can usually find a reason for it , or so called " 事后孔明 （诸葛亮） ”..！

If the market falls sharply, we can explain that investors were worried about interest rates, the economy, geopolitics, company earnings or valuations. If the market suddenly rebounds, we can explain that investors became more optimistic about economic growth, interest rates or corporate profits.

The explanation may even be completely correct.

But knowing why something happened does not mean we could have accurately predicted it beforehand.

This distinction is important because investing is not about explaining yesterday. It is about making decisions today when tomorrow's information is still unknown.

Before an event happens, there are many possible outcomes. After it happens, there is only one outcome, and therefore the explanation seems much clearer. That can give us a false sense of confidence about our ability to predict the next event.

Why I do not set a yearly return target

This is one of the reasons why Uncle does not tell himself that his portfolio must make 10 percent every year.

What does a 10 percent annual target really mean anyway?

Suppose the portfolio falls 15 percent in March, recovers strongly in the second half of the year, and eventually finishes the year up 10 percent. Technically, the target has been achieved, but the journey would have been very different from a portfolio that steadily gained 10 percent throughout the year.

Another portfolio might rise 20 percent in the first few months, fall sharply during the middle of the year and eventually finish at the same 10 percent return.

The final number is identical, but the experience is completely different.

This is why I think we sometimes give too much importance to the annual return figure and too little attention to the uncertainty behind it.

The market does not move according to our calendar, and it certainly does not know that we have decided that our portfolio should make 10 percent by December 31.

The danger of making the target a responsibility

The bigger problem comes when an annual target stops being an expectation and starts becoming something we feel responsible for achieving.

Imagine that you have decided that your portfolio must make 10 percent this year, but after six months you are only up 2 percent.

Suddenly, you feel that you are falling behind.

You start looking for ways to increase your return, perhaps by buying more aggressive stocks, concentrating your money into a particular sector, trading more frequently or taking positions that you would normally consider too risky.

Then suppose the market continues to disappoint you and your portfolio ends the year with only 3 percent.

Instead of accepting that it was simply a weak year, you may feel that you need to make up for the shortfall the following year.

Now you are no longer investing according to the quality and valuation of the businesses you own. You are investing according to a number that you wrote down many months earlier.

This is where things can become dangerous.

A target that was originally intended to create discipline can end up encouraging us to take more risk.

The temptation to play catch up

I think this is one of the most underappreciated dangers of setting aggressive annual return targets.

If someone believes that he needs to make 15 or 20 percent every year, then a poor year can create a psychological problem because the investor starts thinking that he needs an even better year to catch up.

A portfolio that falls 10 percent does not simply mean that the investor has experienced a bad year. In his mind, he may now have a hole that needs to be filled.

That can lead to increasingly risky decisions.

He may move into speculative companies because they appear capable of producing much higher returns. He may concentrate his portfolio into one particular sector because he believes it will recover quickly. He may use leverage because ordinary investment returns no longer seem sufficient to achieve his target.

Ironically, the attempt to recover from a disappointing year can create an even bigger loss.

The market does not become more predictable simply because we are behind our target.

If anything, we should probably become more cautious when we feel the strongest urge to make back lost money quickly.

I am comfortable with having a bad year

For me, there is nothing particularly frightening about the possibility that my portfolio could have a negative year.

If I am investing over decades, I do not expect every year to be positive.

There will be years when the economy is strong and companies are doing well, and there will be other years when markets struggle because of recession, higher interest rates, geopolitical problems or simply poor investor sentiment.

That is part of investing.

If I own a diversified portfolio of businesses across different sectors and markets, I can accept that some parts of the portfolio will perform badly from time to time.

I do not need every investment to make money every year, just as I do not expect every business in the economy to grow at the same pace every year.

What matters more to me is whether the portfolio remains fundamentally sound and whether the investments I own continue to have reasonable long term prospects.

Diversification gives me room to be wrong

This is also why I prefer to spread my investments across different sectors and markets rather than trying to identify one perfect investment idea.

I may own banks, energy companies, consumer businesses, property related companies and other sectors, while also having exposure to different markets such as Singapore and Hong Kong.

The purpose is not to make every part of the portfolio perform equally well.

That would be unrealistic.

The purpose is to avoid having my entire financial future depend on one particular economic outcome being correct.

When one sector is struggling, another may be doing better. When one country is going through a difficult period, another market may offer better opportunities. Sometimes everything may be weak at the same time, but diversification still gives me a better chance of surviving the difficult period without being forced into a bad decision.

It also allows me to admit that I do not know which sector will be the best performer next year.

I do not need to know.

Let the market decide my return

So for Uncle, investing is not about deciding in January that the portfolio must make 10 percent and then spending the next twelve months trying to force that number to happen.

I would rather build a portfolio that I believe can survive different environments and then allow the market to determine the actual return.

If the portfolio makes 12 percent, I am happy.

If it makes 7 percent, that is perfectly acceptable.

If it makes 3 percent, I do not consider the year a failure.

And if the portfolio falls in a particular year, I will look at the reasons behind the decline and ask whether the underlying investments have fundamentally changed. If the businesses remain sound and the valuations remain reasonable, there may be no reason to make a dramatic change simply because the annual number happens to be negative.

Sometimes the best response to a disappointing market is simply to remain patient.

Investing does not need to be so complicated

I also think this approach makes investing much simpler.

There is a tendency among investors to build increasingly complicated models because we want to feel that we have better control over an uncertain future.

We forecast economic growth, interest rates, inflation, currency movements, company earnings and valuation multiples, and then combine all these assumptions to calculate what we believe the market should return.

There is nothing wrong with financial analysis, and I certainly believe investors should understand the businesses they own.

But at some point, more calculations do not necessarily produce more certainty.

If the assumptions themselves are uncertain, making the model more complicated does not magically make the future more predictable.

Sometimes a simple decision based on valuation, business quality, diversification and patience is more useful than a highly complicated forecast that gives us a false sense of precision.

I would rather prepare than predict

This is perhaps how I now think about the market.

I do not want to spend too much energy trying to predict exactly what will happen. I would rather prepare myself for different possibilities. If markets rise strongly, I have investments that can participate in the growth. If markets remain flat, I can collect dividends and wait. If markets fall, I have the diversification and patience to remain invested rather than being forced to sell everything in panic. If attractive opportunities appear, I want to have enough flexibility to take advantage of them.

This approach accepts that I cannot control the market, but I can control how I prepare for different outcomes. That is a much more realistic objective.

There is nothing wrong with saying "I don't know"

Perhaps one of the most useful things an investor can learn is that saying "I don't know" is not a weakness.

I do not know where the STI will finish this year.

I do not know whether Hong Kong stocks will outperform Singapore.

I do not know exactly when interest rates will change.

I do not know what oil prices will be next year, and I certainly do not know what unexpected event might suddenly affect the markets.

But I can still invest sensibly despite not knowing these things.

I can look for companies with good businesses, healthy balance sheets, reasonable valuations and the ability to generate cash over time. I can diversify across sectors and markets, avoid excessive risk and give my investments enough time to work.

I do not need to know exactly what will happen next year to invest for the next twenty years.

The market does not owe us a return every year

I think this is where many investors become unnecessarily frustrated.

We look at our portfolio and feel that it should produce a certain return every year because that is what our financial plan says.

But the market does not work like a fixed deposit. There is no guaranteed 10 percent waiting for us at the end of every December.

One year could produce 20 percent, another year could produce negative 15 percent, and another might barely move at all.

What matters is what happens over a sufficiently long period.

A portfolio that compounds at a reasonable rate over many years does not need to deliver the same return every single year.

In fact, trying to make the annual returns look smooth can sometimes push an investor into taking risks that were never necessary in the first place.

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Final thought

After spending many years investing, I have become less interested in predicting what the market will do in the next twelve months and more interested in making sure my portfolio can survive whatever the next twelve months bring.

For me, that means having a diversified portfolio across different sectors and markets, owning businesses that I am comfortable holding for the long term, keeping my expectations realistic and avoiding the temptation to chase returns simply because the portfolio did not perform as well as I had hoped.

I do not set a yearly return target because I know that the market can surprise us in ways that no spreadsheet can fully anticipate.

There will be years when everything seems to go right, and there will be years when almost everything goes wrong. There will also be plenty of ordinary years that nobody remembers.

I am comfortable with all of them.

If my portfolio makes 10 percent, I will accept it.

If it makes 5 percent, I will accept it.

If it has a negative year, I will accept that too, provided the underlying investments remain sound and my long term plan has not changed.

The important thing is not to let one disappointing year push us into taking unnecessary risks in the following year.

We do not have to chase 20 or 30 percent returns year after year just because we have decided that this is what a successful investor should achieve.

Sometimes the smartest thing we can do is to accept that we cannot control the return, keep the portfolio diversified, stay patient and let the market decide what it wants to give us.

After all, investing is already uncertain enough.

There is no need for us to make it even more complicated by pretending that we can predict the future with precision.

Till next update! Cheers 🥂 

STE 

Disclaimer:

This article was prepared with the assistance of artificial intelligence; readers are advised to independently verify the information and conduct their own due diligence.