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The Source of Superior Investment Returns

I ran across a classic 1993 piece from Financial Analysts Journal today on the subject of consensus, forecasting and investment returns, and it has some points worth repeating. Let’s start with the following:

Everyone’s forecasts, taken together, form the consensus forecast. If your prediction is consensus too, it won’t produce above-average performance even if it’s right [emphasis added]. Superior performance comes from accurate nonconsensus forecasts. Because most forecasters aren’t terrible, actual results fall near the consensus most of the time — and nonconsensus forecasts are usually wrong.

These are, arguably, among the most useful insights you can get on being a successful investor, whether in public or private equity. There are three underlying points:

1. The consensus is the collected “wisdom” of market participants
2. Bucking the consensus is the way to make real money
3. But the consensus is usually right, so bucking it rarely works

This is so important. Because most people not only don’t get past consensus-thinking, they don’t even really know what the consensus is. Put another way, they haven’t figure out yet that the only thing that matters in earnings estimates is the divergence from analyst consensus. More broadly, they have no idea where to begin figuring out which one or two things they currently believe is least likely to hold up in the future. Low interest rates? The centrality of CDMA? The U.S.’s hegemony? $60 oil prices? The current allocation of venture capital to information technology companies? And on and on.

But there is a second-order problem. Having figured out that they need to be nonconsensus thinkers, most people aren’t equipped to figure out where the consensus is actually actionably incorrect. It isn’t enough, of course, for the consensus to be wrong in some way; it has to be wrong in a specific way that you can a) identify, and b) usefully act upon. Which brings us to a second quote from Howard Marks’ FAJ 1993 piece:

…being too far ahead of your time is indistinguishable from being wrong.”

Great stuff.

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