The Value (And Danger) Of Predictions

Rona Birenbaum Just think of how wealthy you could be if you could make accurate predictions! How great would it be i f you knew about the 2008 market crash before it happened, (we’ll return to this one)? Or that the stock market would roar after Donald Trump was elected (this one too)?

Well, yes and no. You’d earn prediction payback only if your prediction was followed by action to profit from the prediction. Pontificating without action is simply being the boring guest at a party whom everyone tries to avoid.

Predictions become currency only when:

The prediction itself is right, and
The timing of the prediction is right, and
You make an investment that profits as a result of that prediction.

You must be successful with all three. Without a 3/3 score, you may experience a loss rather than the gain you were expecting.

Why Don’t We Predict Well?

There are many reasons why human beings make big predictions poorly. But to give you an idea of just how poorly we do, let me introduce you to Wharton professor Philip Tetlock.

Starting in the 1980s, Tetlock collected 28,000 predictions, generating a mountain of data. His mammoth analysis, published in 2005, won an enviable list of academic awards. And one conclusion in the book stood out: The average expert was about as accurate as random guessing – the average expert had no real predictive insight at all.

Here’s another reason for poor predictions. In his June 2018 commentary on The Psychology of Money, Morgan Housel encapsulated what we call the “anchored to your own history bias” when he said: “Your personal experiences make up maybe 0.000000001% of what’s happened in the world, but about 80% of how you think the world works.”

Ben Carlson, institutional portfolio manager and author, pitches in on why human beings predict poorly:

“Hindsight allows us to assume that the past was more predictable than it actually was. Take the Great Financial Crisis. The majority of investors, economists, policy makers and regulators were completely blindsided by the worst economic and stock-market downturn since the Great Depression. Yet, when these same people look back at that fateful 2007-2009 period, it seems many of them now believe that they knew it was coming and called it in advance.”

Or to put it another way, hindsight is 20-20.

But – Humans Need Some Level Of Certainty To Survive And Thrive

Can you imagine waking up without any certainty about how the world works? Where the subway might or might not arrive or exist, road rules were random, and the building you work in would be there some days but not others?

Certainly not.

So how do we deal with the tremendous degree of uncertainty in the world?

We make decisions about reality and predictions about the future that – even if unpleasant or inaccurate – help ground us. As follows:

You are bombarded with information daily.
You can’t possibly process it in a thorough, disciplined manner. So, you filter it through your personal lens.
You focus on the information that aligns with your worldview, the data that supports your opinions. Heck, you don’t have time for the rest!

Back To Trump, As Promised

Now, back to a recent example, as promised at the outset. In 2016, Donald Trump won the Republican leadership. (Do you remember how unlikely that seemed then? Doesn’t it seem more likely now? Just sayin’!)

Soon after, a few clients told us they wanted to sell all their equity funds. They thought, if Trump became President, the stock market would collapse.

At least one of these predictions seemed shaky, so we asked two questions:

Why do you think he will become President?
If he becomes President, why would the stock market collapse?

In general, these clients’ views were intuition and worry rather than beliefs grounded in detailed analyses of the myriad of factors. Together, we decided to leave their balanced portfolios intact.

Donald Trump did become President of the United States – the prediction was right!

But oops – the stock market soared, for almost two years.

I’ll repeat, predictions become currency only when you earn a 3/3 score:

Is the prediction right? Donald Trump became President – correct.
Is the timing right? November election - correct.
Did you make an investment that profits as a result of that prediction? Stocks rallied rather than collapsed – WRONG!

Had these clients sold their equity funds, they would have missed out on the subsequent rally. Over time, seeing the markets rise, and determining after a year or more that Trump seemed actually good for the markets, they probably would have wanted to buy back in … just in time for the recent correction.

The temptation to sell low and buy high has never been greater as investors are bombarded daily with news that seems to require action.

“Apple bombshell sends global investors to safe havens while ‘flash crash’ jolts currencies”.

- Financial post 03 Jan 2019 3:10 AM ET

“The marketís favourite recession indicator — the yield curve — lurches lower”.

- Financial post 02 Jan 2019 10:03 AM ET

“Investors face tough road ahead as top Wall Street economist warns global economic growth now in ‘free fall’”.

- Scott Barlow market strategist published January 2, 2019

Market calls are easy when there are no consequences – so the media loves to sound alarm bells and make bold predictions. Once you have money in the game it gets much harder.

What’s the alternative to making big predictions, or major market calls? Easy, yet extremely difficult – don’t do it!

But isn’t portfolio construction, at its core, about making predictions?

Yes and no. Sound portfolio construction is determined by a relatively small number of factors about which you have a high degree of confidence (but recognize are not immutable).

Your rate of return needs – the minimum return needed to achieve your specific investment goals. Many investors don’t think about that number, or know what it is.
Your tolerance for volatility – how much of a decline can you handle before being tempted to sell before the recovery? How much money in fixed income do you need to protect the portfolio through the next equity downturn, while supporting your income needs in the short term?
Your tax situation. How important is tax efficiency to your financial progress?
The degree to which you want to personally make buy and sell decisions, or delegate.

Now it’s true, the securities chosen by a fund manager represent predictions by that manager. However, these are constrained. They are not major market calls, such as attempting to foresee the near-term direction of interest rates, currencies, or, worse yet, the impact of geopolitical events.

A portfolio manager’s choices are based on the expected value of each given security and its originator, founded on known numerical values. Which are then diversified and balanced to mitigate risk.

So next time you are tempted to fiddle with your well-diversified, balanced portfolio based on a sweeping prediction involving more factors than you can name, remember, it’s not enough to be right. You’ve also got to get the timing AND the market reaction right. Believe me, the odds are not in your favour.

Rona Birenbaum CFP^® founder of Caring for Clients, one of Canada’s premier financial planning firms.

This information is of a general nature and should not be considered professional advice. Its accuracy or completeness is not guaranteed and Queensbury Strategies Inc. assumes no responsibility or liability.