‘Tis the Season for Bold Prediction

In Behavioural Finance, Retail on

It is with a giddy sense of schadenfreude that every year around this time, we get to read bold prediction rubbish like this:

A best-selling personal finance guru, a behavioral economics columnist at MarketWatch, a Harvard-educated economist and other notable financial experts all warn the stock market is going to hell in 2016. Wall Street’s major powerhouses, on the other hand, beg to differ. They see the S&P 500, tracked by the SPDR S&P 500 ETF (SPY), rallying anywhere from 7% to 11% from current levels amid continued economic growth, robust consumer spending and reasonable stock valuations among myriad other reasons.

Why are we giggling like a small child in a candy store?  Because at least one of these groups is guaranteed to be embarrassingly wrong, and there’s a pretty good chance that both groups will end the year scrambling for excuses as to why their crystal ball was, well, cloudy.

The same article quoted above continues with gems – this one sourced from UBS – like:

Simply put, barring an unforeseen external shock or a recession, if earnings continue to improve, 2016 should be a positive year for U.S. equities…Regardless, we continue to expect further volatility – which, in essence, means higher risk, both upside and downside.

Oh, you don’t say: If there’s no recession and profits rise, stock prices will go up?  And, the stock market will be volatile, but that could manifest as either rising or falling stock prices?  And, for those interested in risk management, you’ve acknowledged the possibility that an unforeseeable event might happen?

It takes a lot of talent to write so many words without actually saying anything.

Sadly, at this time of year we are all inundated with this kind of senseless, or useless, or outright dangerous dreck.  Which means that it’s also the time of year that we like to revisit all of the interconnected flaws which create the conditions where this type of drivel can thrive.

The Flaws of Our Lizard Brains

We’d like to hold you blameless, but unfortunately you’re a big part of the problem.  Your fault is unintentional and biological, but still, if predictions pieces didn’t get read, they wouldn’t be published.

As we’ve written many times in the past, the human brain is not wired for objective assessment.  Through the ages, environmental influences drove our brains to evolve survival mechanisms that interpreted the world by observing – and ultimately inferring – causal connections.  These inferences were useful because most phenomena in nature are well described by simple cause-effect relationships , and learning about these relationships kept us alive.  However, the complexity of the modern world, and the divergent payoff structures of investing versus basic survival, make our brain’s heuristic assessment methods terribly anachronistic.

There are other issues at work here, too.  Sensational journalism tends to gain traction because of a potent combination of the halo effect and social herding.  We’ve been covering these concepts for years.  In fact, all the way back in 2011, we wrote:

It turns out that people generally are sensitive to two dimensions of risk. First, there is the risk of absolute failure. For most investors, this is the risk of running out of money before you die. But from a psychosocial standpoint, it feels equally important to manage the risk of relative failure – that is, the fear of not keeping up with your friends. We can summarize the differences between the two types of risk from a financial perspective with the following matrix.

absolute relative success

While clients are anxious about not achieving absolute financial success, they are far more comfortable with the notion so long as all of their friends follow the same process, and end up in the same boat. If all of their peers invest the same way and experience a poor result, they can all commiserate together, and this becomes tolerable.

However, people are typically wary of adopting an approach that is different from their peers, because they run a far more terrifying risk: that they will fail while their friends are successful. This outcome is truly intolerable.

The Motivation Behind Bold Prediction

As writers ourselves, we believe that it is ethically insufficient justification to say that content should be published simply because someone will read it.  No, to us the content itself must have inherent educational or journalistic merit.  And with that in mind, it is fair to wonder whether the outlets that publish these pieces are cynically seeking the revenue from ‘click-bait’ headlines, or whether they erroneously believe that the pieces are helpful.

To us, neither answer is satisfactory.

Beyond the institutions, we must also acknowledge the conflicted motivations of the authors themselves, whose reputations are, sadly, built not on the accuracy of their predictions, but rather on the media recognition itself.  The tragic incentives here dictate that the bolder – and hence less likely – the prediction is to actually happen, the more glory the predictor reaps if it happens to come true.

As a case in point consider Meredith Whitney, who rose to stardom in 2008 by accurately predicting the fall of the major global banks.  At the time she went so far as to say “It feels like I’m at the epicenter of the biggest financial crisis in history.”  Riding the wave of popularity, she was able to establish her own research firm in 2009, Meredith Whitney Advisory Group (MWAG), and establish a hedge fund later in 2013.  Clearly, the lottery-like benefits of nailing a prediction can be immense.

What to Actually Pay Attention To

But prediction is a cruel mistress, as Whitney learned in late 2010 when she predicted – on 60 Minutes, no less – that 50 to 100 cities and counties would go bankrupt over the ensuing 12 months, to the tune of “hundreds of billions” of dollars.  This prediction still hasn’t materialized, of course.  And the lack of accuracy in her post-2008 predictions has largely been credited with the dissolution of MWAG, the closing of her hedge fund, and her 2015 decision to end her career as a money manager.

This is why, at ReSolve, prediction is a “four letter word.”  We’re not in the business of weaving qualitative tales about events that will happen in a specific time-frame, even if such narratives might have an immense emotional appeal to our readers.

We’ve been especially hesitant to write narrative-based commentaries since we learned about the Dunning-Kruger effect.  The Dunning-Kruger effect describes the inverse relationship between expertise and confidence, where a novice in a subject is incapable of knowing how little he understands, because he lacks meaningful experience with the subject matter.   In our experience, this effect is especially prevalent in investment domains, where most investors lack context for the extremely random nature of the process.

Figure 1. Graphical representation of the Dunning-Kruger effect.

DK_Circles

In the context of experts making bold predictions in a complex field, it’s worth asking, “Who do we think is more capable of understanding their limitations: the novice, or the expert?”  And if the expert better understands his limitations, is he more or less likely to make bold predictions?

If there is an inverse relationship between confidence and expertise, so too must there exist an inverse relationship between boldness and accuracy.  That’s why we think investors should ignore any and all bold predictions for 2016.

As with every year, the sheer number of players virtually guarantees that someone will win the “prediction lottery.”  But as with every year, it won’t be us.  We’ll be spending our time improving on our proven investment processes, and generating educational content – like our recently released Navigating Asset Allocation when Diversification Fails – that is cautious, sometimes hedged, and always backed by evidence.  It might not be the sexiest thing to read, but it will be most likely to get you where you want to go.