Credit: Shutterstock photoLow oil prices will tank the energy industry. Controversy over fast-track trade will harm U.S. exports. Slow economic growth will stifle the stock market. You hear a lot of predictions, especially in the harrowing aftermath of the financial crisis. This augury is an insidious racket, though, as behavioral research shows.
As a species, we have a demonstrated aversion to ambiguity and a need for control. Resultantly, it is in our nature to look for patterns where none exist. Humans, expert or otherwise, are just bad at making predictions.
We celebrate successful forecasts as a result of skill, while attributing mistakes to bad fortune. A good investment is the result of intelligence and preparation whereas a bad investment is the fault of extraneous events. Our ill-conceived perception of successful pattern recognition reinforces an already inherent overconfidence bias .
In a famous Yale study, undergraduates had to predict where a rat would find food in a T-shaped maze, with food placed on either the left or right side for each trial. Although the food placement was random, the students erroneously found a pattern they used to foresee where the rat would find the food most often. They were wrong.
Even the highly educated experts on TV and radio, who are paid to make calls, are no better at predicting the future than you, me or the experiment rat.
Renowned behavioral psychologist Phillip Tetlock spent nearly 20 years examining the forecasting ability of experts and wrote an excellent book titled Expert Political Judgment on the findings. His study of 284 people who made a living "commenting or offering advice on political and economic trends" may be the most expansive study of expert predictions ever conducted.
These experts made predictions about the future on questions like would George W. Bush be re-elected, would the dot-com bubble burst and whether gross domestic product growth would exceed a certain level.
The results prove that we are better off relying on random guesses for forecasts of the future than on economic or political experts, who write books, appear on TV and talk radio.
Tetlock writes: "Even the most astute observers will fail to outperform random prediction generators - the functional equivalent of dart-throwing chimps."
Lousy forecasting has a real impact on investors. There are two simple, powerful, and behaviorally difficult lessons for successful investing:
1) Ignore the experts. Tetlock's data demonstrate that education, expertise or even knowledge of confidential information are not useful determinants of forecasting success. In fact, the more confident a forecaster is about the future, the greater depth of the expert's knowledge (beyond a certain point), or the more famous the expert is, the less likely the predictions from such experts are accurate.
Why are forecasters are so poor at their job and why does the public continues to value their advice?
First, we are all inherently biased to overweight the likelihood of low-probability events. Robust behavioral research demonstrates that human brains have trouble comprehending probabilities and forecasters are no different. Second, elaborate stories are more compelling than simple probabilities, so forecasters give us what we want. Third, forecasters become successful not by hitting singles but by hitting home runs - making the prediction that no one else saw coming.
As a result, the most prominent forecasters are not successful because their predictions are accurate but because they create elaborate, well-reasoned and unique predictions that differ from the mainstream. Incumbents win over 85% of congressional elections and the U.S. stock market produces a positive return in 87% of all five-year periods.
But forecasters do not make a name for themselves by simply predicting that such high-probability events are likely to persist. They instead become famous by creating imaginable narratives to explain why incumbents are likely to be defeated or the stock market is likely to fall over the next five years. Quite simply, they swing harder for forecasting home runs.
When occasionally correct, Tetlock notes, "forecasters are skilled at concocting elaborate stories about why fortune favored their point of view." When wrong, they succumb to the hindsight bias - systematic misremembering of past predictions and claiming they knew more about the course of history than they actually knew.
There is no shortage of free expert opinion on the direction of interest rates, oil prices, the dollar or stock prices. Yet most advice is free for a reason. We would all be well served to rely on historic evidence and probability rather than a forecaster's plausible story about why the dollar is likely to appreciate or interest rates to rise.
2) Ignore our instincts . It is easier to criticize experts' mistakes as forecasters than it is to look admit our own predictive failure. The reality is that we're all lousy at prediction, even if we have convinced ourselves otherwise. Our inherent behavioral biases cause us to make bad decisions and to look for meaning when there is none.
According to Tetlock, "human performance suffers because we are, deep down, deterministic thinkers with an aversion to probabilistic strategies that accept the inevitability of error. We insist on looking for order in random sequences." Furthermore, we hate to be wrong.
Inherently tempted to look for patterns, many investors continue to chase returns, jumping in and out of the stock and bond markets despite robust evidence to indicate the high cost of this futile exercise . This puts them in control and that is far more appealing than an admission of the alternative.
There are three types of investors. Those who:
- know they don't know the future direction of financial markets;
- don't know that they don't know; and
- know that they don't know but get paid to pretend they do.
My firm is admittedly in the first category of investors. As a result, our investment discipline ignores market forecasts of our own or others.
We do not seek out the next great star fund manager. We dispose of our pride and recognize that human tendency is to behave badly as investors. We ignore our hunches, ignore the experts, and rely on long-term disciplined investing, adding incremental value through less glamorous value-added steps such as diversification, asset location, factor-tilting and cost-managed rebalancing.
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Jason Lina, CFA, CFPisLead Advisor at Resource Planning Group Ltd. in Atlanta. Website: www.rpgplanner.com .
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
