Mon09012014

Business & Real Estate

Why expert predictions are worthless

By Artie Green I wrote an article earlier this year about a McKinsey study that estimated that media analyst predictions regarding S&P 500 Index earnings growth have been significantly wrong nearly every year out of the last 25. Now, thanks to a recent book by Dan Gardner, “Future Babble: Why Expert Predictions Fail and Why We Believe Them Anyway” (McClelland & Stewart, 2010), we can understand why. Gardner pulls together compelling evidence to explain that expert predictions fail for two main reasons. First, the world is too complicated to be predicted accurately. Think about how many variables influence economic growth – or stock prices. We simply do not have the mathematical and computational tools to predict these kinds of things with any sort of accuracy. The second reason may be even more profound: It’s the way our brains are wired. People have an instinctive aversion to uncertainty. We want to know what is happening now and what will happen in the future, so we try to eliminate uncertainty any way we can. We see patterns where there are none. We treat random results as if they were meaningful. And we embrace simple narratives that replace the complexity and uncertainty of reality. Enter the experts. They have certifications, awards and, most of all, confidence. These are the kinds of people the media love, with their preference for the simple and the dramatic. These experts communicate as if they are certain what will happen, and we like that because that is the way we want to feel. We believe them because we want to believe them. And therein lies the trap. The truth is that there are no crystal balls and no techniques for predicting the future. But there will always be fortunetellers and prognosticators as long as we are willing to listen to what they are telling us. In addition to the many examples of experts who got it completely wrong – Gardner recalls Stanford University biologist Paul R. Ehrlich’s wildly pessimistic prediction in “The Population Bomb” (Buccaneer Books, 1995, originally published in 1968) that by the end of the 1970s there would be massive famines because the world would be unable to feed its exploding population. Gardner cites numerous studies that explain many of the emotional biases toward investing that come under the field of behavioral finance. As he points out, most expert predictions tend to be a continuation of current thinking rather than something unique. It’s a lot easier to see down a straight road than to see around a curve. Remember December 2008? How many experts at that time predicted that by the end of 2009, the S&P 500 would bounce back more than 26 percent? You owe it to yourself to heed what this book is saying. As much as investors might like to believe what someone like Jim Cramer (host of CNBC’s “Mad Money” and best-selling financial author) is telling them, Gardner makes it clear that such people know no more than you do about future stock performance. The safer way to invest is to keep your portfolio as diversified as possible across asset classes that tend not to be highly correlated with each other. That way you don’t even need to worry about predicting the future. As long as there is economic growth over time, the value of such a portfolio should continue to increase. Artie Green, a Los Altos resident, is a certified financial planner and professional investment adviser. For more information, call (408) 747-1222.

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