When In Doubt, Please Don't Predict

by: Vishal Khandelwal

Originally published on June 13, 2016

A leading Indian brokerage - let's not take names here - is in the limelight these days for being consistent in revising its Sensex targets at the drop of a hat. In fact, it has been consistent in such revisions for almost the past two years. But the real beauty of all this lies in the fact that experts from this brokerage have no qualms about ditching their existing Sensex target to adopt the new one.

Just a month ago, its Head of Research appeared on CNBC and advised people to "take the market's exit opportunity with both hands," as he predicted "the Sensex is likely to touch 22,000 mark by the end of this year (March 2017)." He reiterated this target on 31st May.

Then, just a week later, he did a complete U-turn and raised the Sensex target to 29,500, again by the end of March 2017. On a lighter note, I suspect some superstition in this new target, because unlike the earlier rounded-off targets of 36,000 (January 2015), 34,000 (March 2015), 32,000 (May 2015), 28,000 (August 2015) and 22,000 (March 2016), the new target is 29,500 (midway between 29,000 and 30,000).

Superstition or not, I am sure the smart guys at the brokerage haven't heard a wise man's advice...

Never make predictions, especially about the future.

Wait, before you laugh and mock at the above-mentioned brokerage's predictions and wonder why do they continue their tradition despite getting it wrong at all times, know that, if you are a homo sapien, you are most likely sailing in the same boat - making and believing predictions that will most likely turn out to be wrong.

We are wired to be overconfident and over-optimistic, and we are mostly ignorant plus arrogant. Then, in the face of uncertainty like what lies in stock investing, we will cling to any irrelevant number as support, and thus, we cling to forecasts, despite their uselessness.

Forget highly uncertain things like stock prices, we can't even get it right when estimating the cost of a building. The Sydney Opera House, for instance, which was budgeted at an initial cost of US$ 7 million in 1957, ended up costing more than US$ 100 million when it was constructed after a decade. Or consider the Bandra-Worli Sea Link in Mumbai that was originally estimated to cost US$ 98 million, and ended up costing US$ 240 million.

Yours truly has been at the forefront of such failed projections too. I recently renovated my house at a cost that was almost 3x my original estimate at the start of renovation just a couple of months ago. Now, I do not want to bring in my multiple failed predictions (luckily, only known to me) on the stock market here, for that would embarrass me enough to stop writing this post.

We Hate Randomness
You see, we humans are bad at factoring in the possibility of randomness and uncertainty. We overestimate our own knowledge and forget about unpredictability when it is our turn to predict.

For instance, when researchers asked a group of students to choose a range for the number of lovers Catherine the Great had (the correct answer is 22 lovers), 45% of them got it wrong by trying to be precise, even as most of them could have been right by picking a range - say, zero to ten thousand - instead of a specific number.

Consider intrinsic values of stocks. Most of us get it wrong calculating precise numbers for intrinsic values we assign to stocks or the Sensex, even as most of us could get it right when calculating a range of values.

An alien may find our attachment to "precision" funny when it comes to the stock market (though precision is must when you are a brain surgeon or an airline pilot), but this is an ailment that has no cure. We have an intrinsic and uncontrollable urge to be precise, for better or (all too often) worse, which often proves counter-productive when dealing with uncertainty.

This is how Jason Zweig described the human tendency to predict in his book Your Money and Your Brain:

Just as nature abhors a vacuum, people hate randomness. The human compulsion to make predictions about the unpredictable originates in the dopamine centers of the reflexive brain. I call this human tendency 'the predication addition'.

The "prediction addiction", as Zweig explains, is the compulsive desire to try to make sense out of just about everything... even events that are not predictable. Like the direction of the stock market or the future price of a particular stock.

Investment writer Dan Solin, in an article for Huffington Post, wrote:

This addiction is a particularly bad one. Not only are our brains hard-wired to believe we can predict the future and make sense out of random acts, it rewards us for doing so. The brain of someone engaged in this activity experiences the same kind of pleasure that drug addicts get from cocaine or gamblers experience when they enter a casino.

Benjamin Graham put his dislike for stock market predictions this way:

If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what's going to happen to the stock market.

And this is what Warren Buffett has to say on the ability of stock market forecasters:

We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.

Despite such views from great investors on the futility of predictions, investors continue to get conned into engaging in this process, aided by their brokers, advisors and the financial media.

Now, how you safeguard yourself against getting into the unending loop of predictions is simple: Ignore the uncontrollable, and control the controllable.

In simpler terms, what I mean is this. Rather than devoting your time and energy to a "destined-to-fail" attempt at finding the next Page Industries or figuring out where the Sensex is headed in 2016, focus on what you can control.

And what are the things you can control?

  • Expectations: Set realistic goals for the future performance of your stocks. If you think you can beat the market, or earn a return like 30% every year, you're simply setting yourself up for a guaranteed disappointment.
  • Risk: In stock market investing, risk comes from not knowing what you are doing. So, you can control risk by knowing what you are doing. Don't just ask yourself how much you might make if you are right. Also ask how much you can lose if you are wrong. Knowing how much your predication can cost you is a good way to stay away from making one.
  • Behaviour: Leave your emotions aside while investing in the stock markets. Tighten the screws of your leaky brain, and promise yourself that you won't predict where stock prices are headed.

Take a Break
If you are stuck with a prediction addiction, you need a break from the daily cacophony of business channels, financial websites and newspapers firing on their prediction cylinders. Stop looking at the stock ticker. Its constant beat can sometimes cause you to skip a heartbeat. Pursue an investment strategy that does not depend on predicting the unpredictable.

"If owning stocks is a long-term project for you," warns psychologist Daniel Kahneman, "following their changes constantly is a very, very bad idea. It's the worst possible thing you can do, because people are so sensitive to short-term losses. If you count your money every day, you'll be miserable."

Considering what we've learned about how dopamine system works, the ever-changing stock prices hit your brain like a can of kerosene dumped into a campfire.

So, instead of driving yourself crazy by constantly monitoring your stocks, just take a break. Constantly checking stock prices, getting ecstatic or worried about them and making the next prediction will only hurt your personal life and financial returns in the long run.

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