Originally published on June 15, 2016
Whether you realize it or not, every investment decision you make today is based on a prediction about the future.
If we reduce this idea down to its most basic form, it looks like this. When you buy a security, you are predicting that it will be worth more than you paid when you sell it at some future date. When you sell, you make the opposite prediction. (Except for situations where you need the money for an expenditure, in which case you may sell something even though you still believe it will be worth more in the future.)
The problem is that the future is unknowable. Is this a good time to invest in stocks? How about bonds? And what the heck are alternative investments anyway? Should I worry about inflation? What will tax rates be when I retire? Will Social Security still be around in 20 years?
Why We Want To Believe Market Predictions
When we try to answer these questions, we usually turn to market forecasters. We all have our favorite pundits, or our favorite websites, for this. But let's be honest. Market forecasters exist to make astrologists, psychics, and fortune-tellers look good.
So, one of the most healthy things we can do when putting together our investment strategy is to admit that we are making decisions in a framework of uncertainty and unknowns. And that includes our generously compensated investment advisors.
We don't like uncertainty. So we turn to the gurus of Wall Street and we listen to their expert predictions and marvel at the precision of their forecasting models. We believe the predictions of these experts because they're professionals, and they know more than we do. That's true, but it doesn't mean that their predictions are any more accurate than random guesses about the future.
The first rule of predicting is, it's all guesswork.
How Financial Gurus Make Our Beliefs Work For Them
Wall Street, and financial advisors who take us there, have created a world that uses a language that only they can understand. Wall Street is the land of Quants, Smart Beta, and Sharpe Ratios. Wall Street jargon uses Greek letters, standard deviations, and regression models.
But what is behind the curtain of Wall Street wizardry? Forecasting. Predictions. And as Yogi Berra often said, "Predictions are hard - especially about the future." Closer to the truth is an old show-business expression, "Nobody knows nothin'."
What Do We Really Know About The Future?
That has been the lifelong work of academic Philip Tetlock, currently at U. Penn and the Wharton School. Tetlock's latest book is Superforecasting: The Art and Science of Prediction. According to Tetlock, "Forecasting the financial markets is incredibly difficult, despite what the pundits on CNBC would have us believe." He has clearly demonstrated the futility of forecasting the future in his research.
In the end, Tetlock asks whether making predictions is useful: "Making predictions about clear questions whose answers can later be shown to be indisputably true or false may not be either what we want or what is truly useful."
The second rule of predicting is, it's just entertainment.
This is true, of course, if forecasting is merely entertainment. Pundits on television stations, such as CNBC, make predictions constantly, usually with confidence and even a dash of bravado. But most of them turn out to be wrong, or only a random number of them turn out to be right. So why do financial media outlets like CNBC give these experts so much airtime? It's entertainment, the producers will say.
Entertainment? If I want entertainment, I'll watch Dancing With The Stars, or Game of Thrones. When I tune into CNBC, or Bloomberg, it's because I have important decisions to make about my financial future. I don't want to be entertained, I want to be informed.
Here's Tetlock again: "What matters is the big question, but the big question can't be scored. The little question doesn't matter but it can be scored... You could say we were so hell-bent on looking scientific that we counted what doesn't count."
Put differently, we can find people who appear to be better than others at forecasting short-term events, but such events don't tend to be the things that matter. And we don't even have a way of scoring whether some people are better than others - or even better than random chance - on the big questions that do matter.
Given the inability of people, including experts, to be any better than chance at forecasting, Tetlock shows how Wall Street and financial advisors take advantage of us by using a few tricks of the trade. These experts understand that when you don't know something, say it confidently. That's why they often sound as if their forecasts are written in stone and you can take them to the bank. The industry knows that we want our experts to be clear and specific about predictions, and we are willing to overlook their many blunders. These soothsayers are more than happy to provide a false sense of certainty - for a fee.
The third rule of predicting is: nobody knows nothing.
If There Is So Much Uncertainty, How Can I Plan?
The good news is that you can actually make uncertainty work for you. Once you learn to stop worrying and embrace uncertainty, your decisions become much more simple. Accepting uncertainty enables you to set up a simple plan that doesn't require predictions about the future in order to work for you. Once you do that, you can move on to the more important and more enjoyable things in your life.
For example, John Bogle and the folks at Vanguard have been showing us for years that simple broad-based mutual funds provide both diversification and better performance. And guess what, that performance benefit is largely a result of removing Wall Street's "guru fee". While the average growth mutual fund has an expense ratio of close to 1% per year, you can invest in a total market index portfolio for .05%. And if you think that doesn't make a difference, head to Vanguard and try out their free online calculators.
Ignoring the noise of expert predictions and investing in low-cost index funds is just one example where embracing uncertainty can help you be a smarter investor.