Investors crave certainty. They like the idea that there are stock market gurus who understand what’s going on and what to do next. The problem is, that no market pundit can accurately predict the future with any consistency.
When they hear it for the first time, people are often surprised by the phrase evidence-based investing. Surely all professional investment advice is based on evidence, isn’t it? Well, strange though it may seem, the answer is a definite ‘no’. What, then, is most advice based on if not data and academic evidence? Well, to a large extent, it’s based on forecasting.
The problem with forecasting is that it’s very hit-and-miss — and I’m not just talking about the sort of forecasting that financial practitioners engage in. It’s well known of course that the weather people frequently get it wrong. But the fact is that forecasting generally is a notoriously inexact science.
The inability of so-called experts to make accurate forecasts was famously documented by psychologist and political scientist, Philip Tetlock. Between 1984 and 2003, Tetlock analysed the predictions of 284 experts from various backgrounds. Cumulatively they made 28,000 predictions on subjects including politics, economics, climate change and the financial markets.
“Sobering” results
“The results,” Tetlock wrote, “were sobering… Forecasters were often only slightly more accurate than chance, and usually lost to simple extrapolation algorithms. Also, forecasters with the biggest news media profiles tended to lose to their lower profile colleagues, suggesting a rather perverse inverse relationship between fame and accuracy.”
Tetlock provided several possible explanations as to why predictions so often miss the target. Experts, he said, tend to be overconfident and overestimate their ability to predict future events. Some of them are prone to confirmation bias, selectively using information that confirms their pre-existing beliefs. Other experts, Tetlock observed, specialise so deeply in a particular area that they cannot integrate information from different sources or adapt to changing circumstances.
Another, more simple, explanation for inaccurate forecasting is that predicting the future is much harder to do in practice than it is in theory. Nobody seems quite sure whether it was the Nobel Prize winning quantum physicist Niels Bohr or the legendary baseball player Yogi Berra who said it, but predicting the future is difficult, especially when it’s about the future.
Investors crave certainty
Investors naturally crave certainty. Why? Because that’s how human beings have evolved. Certainty was a survival mechanism, allowing for predictable and stable environments, and reducing threats and dangers. When our ancestors could predict food sources, weather patterns, or potential threats, they had a higher chance of survival.
This need for certainty is still deeply ingrained in human psychology. Uncertainty and ambiguity make us feel uncomfortable. So we are inclined to pay attention to those who appear to have made sense of the world and have strong convictions about the best course of action in any given situation.
Investors are no different. They like the idea of making big gains, and they dislike even more the prospect of incurring heavy losses. So they’re greatly influenced by people in the media who appear to have expertise — especially those who’ve delivered strong returns in the past.
What they fail to appreciate is that, in the investment arena, distinguishing genuine skill from plain and simple luck is extremely difficult. They’re fooled by what statisticians call the law of large numbers. In other words, there are so many funds to choose from that, at any one time, there will always be some funds which have performed well in the recent past. These are precisely the funds we tend to read about in the weekend papers. The danger is that we assume that their run of success will continue when, in many cases, performance quickly reverts to the mean and today’s hero becomes tomorrow’s zero.
As academic research and ongoing data from the likes of Morningstar and S&P Dow Jones Indices have demonstrated, only a tiny proportion of actively managed funds outperform the market in the long run on a properly cost- and risk-adjusted basis.
Successful active fund management depends on consistently making accurate predictions. To outperform, a fund manager needs to predict which stocks will generate the highest returns in the future, and which ones will lag the index. Some managers also try to “time the market” by predicting when the index will rise and fall. However, research has consistently shown that both stock selection and market timing are very hard to get right consistently.
The lesson for investors
The lesson is simple: uncertainty is a fact of life, and no one can predict the future consistently.
If even financial professionals, who devote their working lives to studying the economy and the financial markets, and have the latest information and technology at their disposal, struggle to make accurate forecasts, what makes you think that you can do it?
And one more thing. To succeed as an investor, it’s not enough to forecast correctly the result of an election, for example, or even an economic recession. The question is, how will the markets respond to those outcomes? There’ve been many events in recent history that markets have responded to in a completely different way than the experts had expected. The Brexit referendum result and Donald Trump’s victory in the 2016 Presidential election are just two examples.
Certainly, an investor should be very, very wary of letting market forecasts dictate how they invest their retirement savings. They may well come to regret it.
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products.
Robin Powell is a journalist, author and editor of The Evidence-Based Investor.
