Behaviors and Biases

NEARLY EVERY STUDY OF FORECASTING IN ECONOMICS AND FINANCE shows that we human beings are poor predictors of the future. Much of what passes for analysis on Wall Street is really just veiled, half-formed forecasts about the future. As Barry Ritholtz writes: “I wish an SEC-mandated disclosure accompanied all pundit forecasts: 'The undersigned states that he has no idea what's going to happen in the future, and hereby declares that this prediction is merely a wildly unsupported speculation.' ”

Given our collective inability to forecast the future, why do we all persist in doing so?

Some believe like Philip Tetlock, who wrote a notable book on the topic of forecasting and prediction, that we humans have an innate need to feel that the world around us is in some fashion predictable.

 Tetlock states: “There are a lot of psychologists who believe that there is a hard-wired human need to believe that we live in a fundamentally predictable and controllable universe. There's also a widespread belief among psychologists that people try hard to impose causal order on the world around them, even when those phenomena are random.”

It is because we humans hate randomness that many investors have a weakness for pundits with strongly held opinions about the future. The markets often feel like they are a messy, paradoxical

 place. A singular vision about where the markets are headed, even if it is of dubious value, feeds our need for a more predictable world. Investors can get especially sucked in when a market pundit actually gets a big market call correct.

Analysts who correctly called the market crash of 1987 have been living off that call ever since then. The irony is that research shows that those forecasters who get these “big calls” correct turn out to have the worst overall track records. Denrell and Fang show that this has to do in part with how forecasters take into account the full range of available information.

 The trouble is that those forecasters who often take a more measured, probabilistic approach do not feed our need for certainty.

As James Montier notes, the problem is that the worst forecasters are oftentimes the most overconfident.

 Overconfidence is a finding well documented in psychology and behavioral finance, based on the fact that people are routinely surprised by future outcomes. We humans have a persistent belief in our own skills, or that we are above average. Montier also notes that when forecasters are confronted with their erroneous forecasts, they are likely to choose from a list of excuses to avoid having to face up to their failures. Overconfidence is a prime driver of many ill-suited investing behaviors in part because it does not require us to be humble in the face of our own shortcomings.

There are better ways to forecast than to follow the advice of a handful of economists who are doing little more than spinning stories about historical results. Focusing on real-world indicators is a better approach. Earlier in the book, we saw how a simple economic forecasting model based on the slope of the yield curve outperformed economists' predictions. By focusing on indicators that take their cue from real-world decision makers, like the various purchasing manager indexes, we can do a much better job than the chattering classes.

If forecasting the future is largely a waste of time, what should investors do? One approach is to spend more time preparing for unfavorable scenarios. We live a world that is generating all manner of surprises, both man-made and natural. Identifying those major risks and their potential costs is a big first step in creating a forecast-free approach to investing. This requires us to let go of the illusion

 that we can forecast the future and embrace a wider range of potential future outcomes.

We have already seen that stock and bond markets can go down and stay down longer than commonly believed. Investors should take into account scenarios in which the financial markets do not provide positive returns, but in fact generate negative returns. This kind of contingency planning focuses on the downside risks and lets the upside take care of itself. Above all, it meets our goal to move our portfolios, largely intact, from one period to the next.

As we have discussed, strategies like broad diversification and indexed investing have merit in part because they do not rely on forecasts. These strategies recognize our inability to predict with any great precision what certain asset classes or stocks are going to do. By saying “I don't know” to the question of future returns and by diversifying widely and indexing, investors follow a broad-brush approach to investing, capturing capital markets returns in an unbiased way.

The two main investment strategies discussed, value and momentum investing, do not use forecasts as a part of the process. Momentum investing is explicitly backward looking in that it uses past returns as a tool to rank potential investments; the only assumption is that recent past returns tend to persist. Value investing and the search for a margin of safety are necessarily backward looking. Value investors focus on the disparity between the current price of the stock and the true underlying value of the company. Because value and momentum investing both require analyzing the present much more than the future, they avoid the forecasting fallacy. In so doing, these two approaches to active investing are likely to be more consistent and sustainable.

The “prediction addiction,” as Jason Zweig calls it, is a strong one.

 We can, as Zweig suggests, take steps to restrict our ability to tinker with our portfolios, like setting up automatic investment plans. We can also try and test our ideas in a systematic fashion before we put them at risk in the market. Zweig notes how paper trading can be a way to test our capabilities in a lower-risk setting. More often than not, we will find that our ideas are not all that great in practice.

This idea of getting our portfolios largely intact from one time period to the next goes hand in hand with the need to avoid the folly

 of forecasting. A focus on the risks we face is far more important than making some one-time market call. It is not for nothing that Abnormal Returns has as its subtitle A Forecast-Free Investment Blog.

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