Why Most Market Forecasters Get it Wrong

Posted on July 22, 2011 at 9:23 AM PDT by

Be it a football game, the weather, an election, or the future of Middle East uprisings, people want to know what will happen before it does. We want to know the future, and we actively seek out experts who can predict it. But facts show that in most pursuits where dynamic and multiple variables determine what will happen, experts are not good at predicting the future. And to make matters worse, those who predict are rarely held accountable for their prognostications.

Take politics, for example. Philip Tetlock, a psychology professor at the University of Pennsylvania, conducted a study that became a book called Expert Political Judgement. He tracked about 80,000 forecasts from nearly 300 political experts over 20 years regarding political events in many countries. He tracked the outcomes of their forecasts against a group of college undergraduates making subjective predictions and a group who just made random guesses. The experts did slightly better, but not much. Nevertheless, they got on TV frequently and built their names and reputations.

Christina Fang, a professor of management at NYU’s Stern business school, tracked the Wall Street Journal‘s Survey of Economic Forecasts to find out how accurate these highly paid analysts’ forecasts were when billions of dollars were at stake. Surely this would lead to more accurate predictions. Her paper, “Predicting the Next Big Thing: Success as a Signal of Poor Judgement,” draws some stunning conclusions.

Fang concludes that rather than being an indication of good judgment, accurately forecasting a rare event, such as business success, may in fact be an indication of poor judgment. On National Public Radio, she said, “If you look at the extreme outcomes, either extremely bad outcomes or extremely good outcomes, you see that those people who correctly predicted either extremely good or extremely bad outcomes, they’re likely to have overall lower level of accuracy. In other words, they’re doing poorer in general. … Our research suggests that for someone who has successfully predicted those events … they are not likely to repeat their success very often. In other words, their overall capability is likely to be not as impressive as their apparent success seems to be.”

Consider how those who predict make money on Wall Street. Because there is no way to hold financial forecasters accountable for their incorrect predictions, they get more out of making wild ones. Wild predictions pay because the downside of being wrong is zilch, but the upside is lifelong fame. When those who make them are right, they get to manage more money, sell more books, and garner tremendous publicity for many years to come.

Consider the 2008 market crash. The best-selling books today are being written about those who called the crash such as John Paulson and those featured in Michael Lewis’s book The Big Short. Those who were right will continue monetizing their correct prediction for many years to come. They are today’s seers. But literally hundreds of pundits on CNBC got it wrong. Who were they? We’ll never know—no one has any incentive to embarrass those who were wrong. Imagine seeing a pundit on CNBC with statistics showing how accurate their predictions were, like baseball statistics each time a player walks onto the mound.

We face a showdown between Congress and the president on lifting the budget deficit ceiling. The fact is, no one knows when or what deal will be cut. Those who are predicting this outcome are guessing. The ultimate effect on stocks and bonds in the short or long term is also unknown. But we keep tuning in, hoping for an answer, listening to confident and educated individuals making predictions.

As avid index investors, we make only one prediction: In a global, capitalistic economy, investors are rewarded for the risk they take in deploying their capital. If in bonds, investors will be rewarded as a lender. If in small-cap stocks, investors will be rewarded for increased equity risks. This prediction is rooted in empirical evidence and fundamental principals of our economic system. The rest is expensive and distracting noise. Predicting the ebbs and flows of that noise only serves to help money managers increase their assets under management and financial authors to sell more books and newsletters.

So next time you find yourself glued to a financial soothsayer making a prediction, stay far away from the trade button.

 




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