Economist John Kenneth Galbraith once identified two types of forecasters – “those who don’t know” and “those who don’t know that they don’t know”. Adding to this sentiment, legendary investor Warren Buffett observed that forecasts tell you a great deal about the forecaster, but nothing about the future. These perspectives are crucial when listening to market experts and acting on your own predictions. The key is considering how you would react if your views proved incorrect across different time horizons. Such an approach guides you towards right-sizing investments and limiting the risk of being knocked off your investment journey.

The performance gap

Last week, I was looking at the distribution of investment returns, and the lessons from this analysis were twofold. First, it reinforced our experience that the average investor significantly underperforms a ‘buy-and-hold’, diversified investment approach. Indeed, Oxford Risk estimates that the gap between the two is around 3% per year.

For context, our five-year expected return for a balanced investment allocation of 5% cash, 37% bonds, 53% equities and 5% gold is currently 6.2% per year. If we compound USD 1,000 at this rate for 20 years, it would give us USD 3,330 at the end. However, compounding at 3.2% instead results in a total is USD 1,877. Naturally, the longer you do this, the wider the gap becomes (for 30 years, it becomes USD 6,077 vs. USD 2,573).

The psychological barriers to success

There are three key reasons for investor underperformance. First, clients tend to have excessive cash deposits in their portfolios, leading to a drag on performance over the long run. Why do investors do this? In my experience, this can partly stem from simply ‘not getting around to it’ when it comes to embarking on their investment plans. However, it is also because investors recognise that the world is complex and do not want to invest at the wrong time. That is, they know they don’t know what the immediate future holds.

Second, people often lack the holding power when markets move against them. Theoretically, they know ‘this too shall pass’, but their brains scream that they are losing money and that they should sell everything to alleviate that near-physical pain. Morningstar estimates that investors underperformed the funds they held by around 1.2% in 2024 due to mistiming the market – for example, buying after market gains or selling after market declines.

The third reason for underperformance is that people overestimate their ability to pick winners – that is, they don’t know that they don’t know. This brings us to the second lesson from the analysis: the wide distribution of investor returns – ranging from losses of more than 30% to gains of over 50% – suggests many take very narrow positions, hoping for quick returns. Put simply, they believe they know what is going to happen in the immediate future.

Interestingly, we do not normally see different investors neatly fitting into different categories; they are usually the same investors over time and in different situations.

This week, I was discussing the huge success we have had globally with the launch of multi-asset investment solutions that seek to address the three biases above. Clients and Relationship Managers love the solutions because they provide a one-stop solution for a large portion of clients’ needs, delivering strong performance and smoothing the ride. However, they also questioned why a fund that had risen 60% so far this year was not on our platform.

The mental gymnastics required to hold these two views simultaneously is both irrational and normal. To achieve a 60% return in four months requires investors to take a highly concentrated investment exposure, and experience tells us that this can cut both ways. A 60% return today can quickly shift to similar losses tomorrow. Nonetheless, we feel we are missing out, as though the grass is greener, and that we should move.

Planning for the unknown

This is where it is important not to be the second type of forecaster. You need to accept that you don’t know what is going to happen in the future – and neither does anybody else, regardless of how convincing they sound. You then need to make a plan that accounts for long-term expected returns, potential deviations around them and the likely trajectory.

For instance, we know that over long time periods, equities have outperformed other asset classes. However, nobody knows whether this will remain the case, especially in the short term.

To illustrate, let’s take the worst historical experience for an investor since the beginning of the 20^th century – the Great Depression of the 1930s. If you invested in the US stock market at the end of 1928, then including dividends, it would have taken you 15 years to return to profitable territory. Had you invested the same amount every year, the power of dollar-cost averaging would have shortened that to just five years. This is still a long time, but given the Dow Jones Industrial Average Index fell 80% between1928 and 1932, reaching profitability by 1933 is truly amazing.

This is not an environment I expect to see again, given the lessons learnt by policymakers on how to respond to such a situation. However, even if I am wrong on this – if “I know I don’t know” – we can still step back and be quite confident that a diversified portfolio will rise in value over the long term.

The longer your time horizon, the more confident you can be. As such, what will happen in the next day, week, month or even year is highly uncertain, yet it is also largely irrelevant in the bigger scheme of things. The key is to avoid investing excessive proportions of your money in the latest fad or theme, invest the vast majority into a truly diversified portfolio to smooth out the ride, have a plan for when the market corrects and have the fortitude to follow it.