Can You Forecast Better than a Dart Throwing Chimp?

The fox knows many little things, but the hedgehog knows one big thing - Archilochus

Cover Story

Philip Tetlock has spent many years studying the ability of experts to predict important events in their sphere of interest and come to the not entirely astonishing conclusion that they aren't much good at it. Soviet experts, for instance, missed the possibility that the Soviet Union might stop existing. On the other hand, they're exceptionally good at promoting themselves: being wrong is no impediment to fame, it seems.

Tetlock has discovered that people fall into two groups that he labels 'hedgehogs' and 'foxes', Hedgehogs have one big idea and tend to interpret the world in terms of it. Foxes have lots of ideas and are more flexible in the face of change. Unsurprisingly foxes are better at predicting stuff; but does that make them better investors?

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Gaia And The Ambivalent Investor

Delusional

We're very keen on people who are very definite about things – even if it subsequently turns out they're wrong or delusional (or both). We're less interested in people who are less certain about things. We don't value ambivalence in our gurus.

Unsurprisingly we're wrong about this. The ambivalent investor is sometimes that rare thing, a genuinely sensible expert in a field dominated by loud mouthed, impossibly certain charlatans. And mostly it doesn't matter which side of the fence you favour, you'll be better off sitting on it. 

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A Load of Bull

Sporadic Bull 

In a recent (very nice) review the writer described me as a “sporadic blogger” which is, I suppose, nothing more than a statement of fact.  It’s nicely circular, though, as the one of the reasons for the infrequent posting was the subject of the review … 

The book, Investing Psychology: The Effects of Behavioral Finance on Investment Choice and Bias (Wiley Finance), is a review of the current state of behavioral finance for the non-expert – a task born out of hope as much as expectation, I should add, as the subject moves almost as fast as you can research it – and a plea for investors to take care, to avoid the less-than-well-signposted traps.  Finance is a world dominated by people whose relationship with the truth isn't so much tenuous as trivialized.  And a bull market attracts bull merchants like no other.

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Bad Press: The Sad Demise of Financial Journalism

Free Speech

The press have always had a key role to play in the maintenance of democracy.  They have free speech rights which are protected by the courts - in particular they have the right to protect their sources – which other people aren’t afforded.  However, there’s a view that this power brings responsibility, and that responsibility is to hold the rich and the powerful to account.

Yet financial journalists have, with a few exceptions, been conspicuous by their absence when the great financial scandals of the twenty first century have unfolded.  Indeed they’ve often been implicated in the issues, egging on investors with hyped up stories of superpowered CEOs and overly optimistic forecasts.  And, frankly, if financial journalists aren’t able or willing to exercise their duties, should we continue to allow them the rights to do so?

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Things Investors Should Hate 2/5: Gurus

I''m not entirely sure what constitutes the entry qualification to be an investment guru. Intense self-belief and a complete lack of introspection, perhaps?

The best analysts tend to be self-effacing, are often cautious in the face of uncertainty and usually hedge their bets a lot of the time.  Lacking brazen overconfidence they’re less popular, but they’re the safest hands in the business.

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Clueless: Meet the Overprecise Pundits

Bedside Punditry

Most short-term opinions on markets or any system that includes human beings as part of the machinery are generally worthless in a financial sense.  Mostly we can’t predict what side of the bed our children will emerge from in the morning so why anyone should expect to be able to accurately forecast the outcome of the interactions of millions of people remains an abiding mystery.

Despite this reams of words are written each day by pundits safe in the knowledge that today’s news is forgotten tomorrow and that expressing unwarranted certainty is the way to succeed.  They’ve learned that extreme, albeit incorrect, precision will fool most of the people most of the time, and no one ever checks.

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Can Software Beat Penny-Flippers?

"Am I doing better than I could do by flipping pennies?" – Paul Meehl

Denial is Futile

The Abnormal Returns website recently highlighted an interesting little spat on the blogosphere, as commentators argue over the benefits of software based investment advice.  It’s a trend with only one outcome, one that probably doesn’t do investors any good, but equally one that’s sadly inevitable.

What’s more interesting, though, is the creaking movements of tectonic plates as various commentators position themselves uneasily on the cusp of a disruptive change.  You can see the status quo bias at work, but like it or not, change is coming: the markets won’t be denied.

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Forecasting A Financial Earthquake

Guru-nomics

It’s that time of year when every self-respecting student of markets blows the dust off their crystal ball, and sets about attempting to forecast the direction of markets for the next year. Some pore over charts, others examine the history of presidential election years, some analyse market data and others, surprisingly large numbers of others, consult star charts.

Financial forecasters suffer from the same problems as earthquake forecasters – they don’t understand the underlying principles of what they’re trying to analyse. While the latter generally recognise this and have the sense to put in place the appropriate caveats the former mainly seem to be blind to the possibility of error. Of course, the fact that over-confident earthquake analysts may lose their careers and reputations while their equivalent in finance will merely have to wait another year to assay an attempt at guru status may have something to do with this.

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HONTI #6: Distrust the Experts

Rule #6: Don't take experts at face value: check their knowledge and their results.

Trust Needs To Be Earned, Not Assumed

In a complex world we often have no choice but to rely on experts to help guide us. If we’re going to lean on such people, though, we really ought to make sure that they know what they’re talking about. This is certainly true for financial experts, but is equally true in other areas as well: relying on the first medical opinion you get isn’t generally a smart move, either.

It seems there are certain areas in which we actually default to trusting our advisors rather than distrusting them – doctors, teachers, attorneys and so on.  Often this trust is justified, but sometimes it isn't – and when this happens we lose out. It turns out that a default of not trusting our advisors is the safest approach, even if that feels ethically dubious¹. We are, on the whole, inclined to trust people, but mistaking an advisor for a friend is a risky strategy.

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Investment Forecasts: Known Unknowns

End of Year Epiphanies

At the end of every calendar year we experience a rush of forecasts on the likely direction of various markets and stocks for the next year. You can find thousands of such forecasts on the internet and you can’t pick up a paper without someone or other opining on the subject. In fact, no matter what your preference, you’ll doubtless find someone out there predicting whatever you want.

The uselessness of these predictions was carefully explained by the Ancient Greek philosopher Socrates, two and half thousand years ago. Not letting death, the lack of Ancient Greek stockmarkets or the fact he lived in an economy based on slavery get in the way of a good analogy, Socrates noted that he, at least, knew what he didn’t know. Which in investment analysis terms is about as close to an epiphany as you’re likely to get.

From Socrates to Rumsfeld

Socrates seems, as far as we can tell, to have spent his life in philosophical musings, preferring to spend his time asking the supposed wise men of Athens for their insights rather than doing anything more economically useful. His conclusion was, largely, that they didn’t know very much – an insight that echoes down the ages. They, on the other hand, decided that they didn’t like a smartass and the result is a lesson to would-be gadflies the world over.

In particular he seems to have annoyed the powerful by informing them that he knew something they didn’t. Having already upset them by showing up exactly how dim they were he then compounded his crimes by revealing his secret: “I know what I do not know”. If this sounds familiar, you’d be right:

“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.”

It’s long way from Socrates to investment analysis via Donald Rumsfeld but I think we’ve just managed it.

The Known Unknowns of the Market

Socrates’ known unknowns are important for markets, because each of us can know – with something approaching certainty – that one of these is that there are people out there who know more about investing than we do. If different participants have different abilities when it comes to analysing and interpreting information then, by definition, the markets can’t be strongly efficient. Even if we’re all rational we aren’t all equally gifted.

However, if we are all rational then, if we recognise that other people know more than we do, we ought to stop investing actively. After all, if investment analysts and institutions have this much of an edge on us it makes no sense for anyone without demonstrably superior investing skills to try and compete with them. So if we’re rational maximisers then we ought to buy index trackers and content ourselves with sitting on the sidelines watching the heavyweights slugging it out.

Extending this argument, as the least good investors stop competing, the remaining participants will themselves divide into the best and worst groups with the winners taking the spoils. Once again members of the worst group should, rationally, stop investing actively and this process of winnowing should carry on until there is only one investor left. Who then has no one to invest with, leading to the heat death of efficient markets.

The Unknown Unknowns of the Market

Now, obviously, this isn’t what’s happening. Millions of people continue to dabble in active stockmarket investment in spite of having no obvious ability to outperform markets. Even better, they carry on investing even when they’re losing money, failing to learn from their mistakes. These people, who clearly don’t know what they don’t know, are the inefficient grit in the gears of the efficient market. Bless them, because without them value investing couldn’t work.

The behavioural weaknesses of market participants – certainly their overconfidence and lack of insight into the reasons for past underperformance – are clear and powerful drivers of market inefficiencies. Exploiting these inefficiencies should be the goal of all right thinking investors, which means that we need to be constantly looking for where people are behaving most irrationally.

These manifest inefficiencies mean that making anything approaching a detailed forecast is almost impossible. The end-of-year forecasting bonanza, which is largely driven by the need to fill column inches, is one of the odder and more pointless activities humans engage in, somewhere up there with bog-snorkelling and cheese rolling.

Random Forecasts

There’s so much data out there it’s possible to find evidence to support any theory you might like. Someone, somewhere, will be right – which is nice for them, but not much use for the rest of us trying to avoid losing money. Of course, the people who ought to be best at predicting the motion of the stockmarket ocean are those that are paid for the experience: security analysts.

Going all the way back to the original work of Alfred Cowles’ Can Stock Market Forecasters Forecast? in 1932 the evidence for analysts outperforming the market is ambiguous, to say the least. Possibly the best gloss on the situation comes from this paper by Ericsson, Anderson and Cokely who identify that the best analysts do seem to have an edge in making predictions but that seems to be linked to extremely constrained areas of expertise, is not generalisable to wider markets and is too small to be exploitable when costs are taken into account:

“With the possible exception of the advantage of trading by insiders, the advantage offered by expert investors is too small to allow profitable transactions, yet sufficiently large to show reliable gross abnormal returns, before the costs of the transaction are subtracted. From the point of view of expertise research we find that there are consistent individual differences among experts, with experts exhibiting specialization, and demonstrating superior and reproducible investment and forecasting performance”.

So as it stands even the best brains in the business don’t have the ability to outperform the markets so, naturally, the rest of the world – which has next to no experience of market behaviour – expects to outperform the analysts, heaven help us. The only thing that the mass of return seeking mavens has to offer as an advantage over the analysts, who, as we discussed in Rise of the Machines, have the most powerful computer systems, the best researchers and the cleverest algorithms around, is their willingness to outwait the latest trend. Obviously this is, generally, the only attribute they’re not willing to use to their advantage.

Hemlock for the Pundits

The end-of-year forecast frenzy is simply a bit of temporally induced fun which shouldn’t be taken seriously. Recognising not just that we don’t know very much but that most of the people telling us what to do don’t know very much either is an important step towards freeing ourselves from the straitjacket of our social conformity and becoming intelligent investors.

Socrates, of course, ended up drinking hemlock and committing suicide after annoying too many powerful people. That seems like a step too far in search of a perfect investing strategy but being willing to go against the trends and to ignore opinion is absolutely critical. So if you must read the pundits’ predictions at least do so usefully: write them down and then compare them with what actually happens.


Related Articles: Contrarianism, Regression To The Mean: Of Nazis and Investment Analysts, Technical Analysis, Killed By Popularity

What’s the Shape of Your Recession?

Clueless Commentators

Over the past few years we’ve had endless economic experts opining on the nature of the recession. From initial hopes of a bouncy V shaped recovery we moved onto a sluggish U and then a very droopy looking L before a dose of government pump-primed financial Viagra re-erected the idea of the V. More pessimistic predictors – mainly those who originally plumped for a U or an L – are now hopefully suggesting that we’ll get a double-dip W or a triple-dip VW in an attempt to save their remaining credibility.

Of course, the reality is that none of them have the faintest clue because none them possibly can have the faintest clue. We are, as always, in the uncharted waters of the future. The only letter that needs apply is the X that marks the spot where we bury the commentators and their useless predictions.

Blithe Ignorance

As we’ve sailed on through the treacherous shoals of economic uncertainty people have naturally looked to the world’s experts for advice. Occasional suggestions by central bankers, who actually have the real data to analyse, that they don’t have a clue what’s going to happen have resulted in shudders across world markets. Meanwhile commentators have happily carried on making essentially random predictions based on their thirty years or so experience of largely benign economic times. It’s like watching a weather forecaster from Hawaii trying to make predictions for the Mid-West: amusing, but not terribly helpful.

In fact, as economies have uncertainly recovered we’ve seen the standard reactions by experts who’ve been caught out (see You Can’t Trust The Experts With Your Investments). Many have simply ignored the fact that they were wrong and have blithely continued to make further predictions; presumably on the grounds that yesterday’s media makes tomorrow’s lining for kitty litter trays. Others have opted for the standard “I was right, but not yet” or “I was wrong, but for the right reason” responses as though getting your timing wrong about the world economy and causing people to flee into overpriced government bonds just as the biggest stockmarket rally in history kicked off is a normal sized mistake.

The highly respected John Authers of the Financial Times is one of the few who’s come out and admitted he got it wrong (which is one of the reasons he’s respected). However, the one point he should have made, but didn’t, in “OK I called the rally wrong” is that picking the trends that were important is easy with hindsight but was impossible to do with certainty at the time.

The Two Rules of Ignorance

Still, a few rare experts called it right, at least temporarily, and their opinions are increasingly and eagerly sought. The problem is that simply being right last time is no proof that they can get it right next time. In investment, of course, next time is the only time that matters – hindsight is a perfectly useless investment tool.

Unfortunately we’re at least partially programmed to look for advice from experts. In an increasingly complex world we know, as a proportion of total knowledge, less and less. We’re four hundred years past the time when one person could hope to know everything yet many of the decisions we’re called upon to make are horribly complicated and not having a guide to help us is impossible much of the time.

There are, roughly, two loose rules humans follow when called upon to make decisions that lie outside of our area of expertise. One is to follow the crowd, the other is to follow the expert. Both are decent shortcuts much of the time, both are highly dangerous in investment.

Herding

Following the crowd, although much derided, is a perfectly good strategy in lots of circumstances. Doing what everyone else is doing in an unfamiliar setting is as good an approach as any. If everyone else is eating the dodgy looking purple mush then it’s a safe bet it’s not poisonous – although there’s no guarantee it’s not disgusting (trust me, it was really disgusting). Herd following has a long and honourable history, and is certainly evolutionarily adaptive – children habitually copy their parents and other adults in order to learn more advanced behaviours. You know, stuff like getting drunk, betting on lame horses, buying overpriced property and reading magazine articles on talentless micro-celebrities who’ve the star quality of a dead skunk.

Of course, in individual investing, herding is often the wrong thing to do assuming that we’re trying to maximise our wealth. Although, it should be noted, the momentum effect – where shares that have gained continue to do so and losers continue to fail – is extremely persistent. The problem with this is that shares do, eventually, tend to mean revert and that usually catches the crowd unawares.

Ask The Expert

The alternative, to ask the expert, is also a method with a decent pedigree. In science based areas where there’s a dispute it’s a reasonable rule of thumb to go with the side that has the most experts, although not everyone completely agrees as David Coady sets out in When Experts Disagree. For most of us this has the most direct impact in medical matters. So, for instance, in the recent debates over whether the MMR jab could cause autism the vast weight of the establishment came down in favour of children having the inoculation. The dangers of not having it were real, the dangers of taking it uncertain and the risks, as usual, were exaggerated by the headline obsessed media.

Unfortunately experts aren’t always right. The advice of the child-rearing expert Dr. Spock to lay babies on their stomachs is now the exact obvious of the expert opinion in regards to cot-death. As Ben Goldacre has repeatedly written about on his Bad Science blog, pharmaceutical funded research consistently shows a bias in favour of positive results that isn’t seen in independently funded studies. This isn’t evidence of deliberate bias by the researchers, however, since we’ve seen before how unconscious psychological drivers can lead to this type of reporting.

Investment Advice

In non-scientific areas of research, like investment, the problem is much harder. The issue is that we’re not dealing with matters of fact but with matters of opinion. Mostly there is simply no consensus to base a decision on and we tend to gravitate to the expert who’s been most recently right. Unfortunately, if expert opinion is truly random then the most recently correct experts are probably those least likely to be right in future. But in truth, we don’t know.

So in financial matters our two most favoured short-cuts in areas of specialist expertise are almost bound to leave us in the lurch. Of course, mostly we follow these routes so automatically that we’ll go ahead and use them anyway, like a driver following a sat-nav over a cliff edge. The alternative is to try and acquire sufficient knowledge to do the job ourselves and here we tend to fall victim to a different bias – the idea that because it’s easy to do something it’s easy to do it well.

Simply being able to log on to a sharedealing site, purchase a few shares and see them roar is no evidence at all of investment expertise. In fact, there’s a good case for arguing that the easier it is to get access to a means of making money the harder it actually is to do so. Consider blogging, an activity engaged in by everyone from five year old toy collectors to octogenarian needle workers. Anyone can do it, which means making money from it is virtually impossible for new entrants: that’s the nature of basic economics.

Good Enough Expertise

As so often the best advice in this area comes from Charlie Munger who observes that in order to make difficult technical decisions you need to employ an expert and then gain sufficient knowledge personally to at least cross-check that they know what they’re doing. In investment that roughly equates to them not chasing every trend, not trusting research done by others and having a clear understanding of the fundamentals of valuation techniques and competitive advantage.

For the most part, though, you don’t want an expert who spends their time opining on the shape of nebulous concepts like recessions. Better find one that actually spends some time thinking.


Related Articles: Technical Analysis, Killed By Popularity, Ambiguity Aversion: Investing Under Conditions of Uncertainty, You Can’t Trust The Experts With Your Investments

You Can’t Trust the Experts with Your Investments

Investment Experts Make You Poor

In a complex world we increasingly have to rely on experts such as lawyers, doctors and scientists to guide us. We expect them to get things right most of the time and we sue the hell out of them if they don’t. In the world of investment, though, we get something different. They get it wrong most of the time, are never held accountable and generally argue that they actually didn’t get it wrong anyway and, if they did, it wasn't their fault.

Meanwhile people listen to these “experts”, take their advice, almost hero worship them at times and mostly get poorer while they make money at our expense. Who are the smart ones in this relationship?

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