“All that had changed was people’s opinion of the place”

“The Commanding General is well aware the forecasts are no good.  However, he needs them for planning purposes.”

– Kenneth Arrow, Nobel Laureate Economist…recalling the response he and colleagues received during the Second World War when they demonstrated that the military’s long-term weather forecasts were useless. (via Future Babble)

Virtually every day there are pundits and gurus on the airwaves, internet, and print making predictions.  At the beginning of 2011 a few of these gurus made some pronouncements as to the future returns of the US stock market.   Laszlo Biryini contended that the S&P 500 (currently trading at 1300 as of this writing – sorry, wrote this about a week ago) would rise to 2854 by 2013, or a 120% gain from current levels.  Robert Prechter, on the other hand, said he thought the Dow would decline 90% by 2017, which would imply that the S&P 500 trades down to around 130.

So there you have it, opposing gurus who believe that stocks will either rise or decline by 30% annualized over the next number of years.  (To complicate the matter even further, you have Shiller estimating the S&P 500 to gain about 10% total by 2020 which splits the two gurus in half.)

Interestingly enough, if you combine the current S&P 500 level (1300, PE of 23) with the lowest (5) and highest historical values (45) for the Shiller cyclically adjusted price earnings ratio (CAPE) you get to values similar to the forecasts at both ends (300 and 2600).  I think the most interesting but unlikely forecast is all three being correct over various timeframes!

The only difference between the S&P500 at 300 (an 80% decline) and the S&P500 at 2600 (a near double) is opinion, namely, what you think those underlying stocks are worth.  Now, we could certainly go on and on making well-thought out arguments as to why either value is justified (low/high interest rates, profit margins, productivity, mean reversion, discounted cash flows, etc.), but at the end of the day it is simple human beliefs on the value of stocks that drive their short term price levels.  As the late, great Kurt Vonnegut opined in his book Galapagos, circa 1985:

“The thing was, though: When James Wait got there, a worldwide financial crisis, a sudden revision of human opinions as to the value of money and stocks and bonds and mortgages and so on, bits of paper, had ruined the tourist business not only in Ecuador, but practically everywhere…Ecuador, after all, like the Galapagos Islands, was mostly lava and ash, and so could not begin to feed its nine million people. It was bankrupt, and so could no longer buy food from countries with plenty of topsoil, so the seaport of Guayaquil was idle, and the people were beginning to starve to death…Neighboring Peru and Columbia were bankrupt, too…Mexico and Chile and Brazil and Argentina were likewise bankrupt – and Indonesia and the Philippines and Pakistan and India and Thailand and and Italy and Ireland and Belgium and Turkey. Whole nations were suddenly in the same situation as the San Mateo, unable to buy with their paper money and coins, or their written promises to pay later, even the barest essentials. ..They were suddenly saying to people with nothing but paper representations of wealth, “Wake up, you idiots! Whatever made you think paper was so valuable?”

The financial crisis was simply the latest in a series of murderous twentieth century catastrophes which had originated entirely in human brains. From the violence people were doing to themselves and each other, and to all other living things, for that matter, a visitor from another planet might have assumed that the environment had gone haywire, and that people were in such a frenzy because Nature was about to kill them all.

But the planet a million years ago was as moist and nourishing as it is today – and unique, in that respect, in the entire Milky Way. All that had changed was people’s opinion of the place.

How does an investment manager reconcile all of the various prognostications he hears on a daily basis?

Simple – ignore them.

Now I am not recommending to completely ignore the basis behind the arguments, as many new approaches and research projects have been originated by ideas presented in print and on TV.  But in general, one should ignore the forecasts of so called experts as they are likely to be about as accurate as a monkey throwing darts against a wall or a coin flip.  There is enormous amount of research to back up the inability of experts to make solid predictions.

One such researcher on expert predictions is Philip Tetlock, a professor of management at the Wharton School at UPenn . He started tracking experts and their forecasts and predictions a quarter century ago, and he has compiled over 300 professionals and academics that have made over 80,000 forecasts. (Here is Tetlock’s home page as well as a sample book chapter. Daniel Drezner has two excellent posts on the book, here and here, and a review from The New Yorker.)

He examined both the outcomes of their predictions as well as their processes – i.e. how they reacted to being wrong and how they dealt with contrary evidence.  In general they offered no benefit over a random prediction, and ironically enough, the more famous the expert, the less accurate the predictions were.    The experts with the least confidence made the best predictions.

Tetlock states:

 “Isaiah Berlin borrowed from a Greek poet, “The fox knows many things, but the hedgehog knows one big thing”? The better forecasters were like Berlin’s foxes: self-critical, eclectic thinkers who were willing to update their beliefs when faced with contrary evidence, were doubtful of grand schemes and were rather modest about their predictive ability. The less successful forecasters were like hedgehogs: They tended to have one big, beautiful idea that they loved to stretch, sometimes to the breaking point. They tended to be articulate and very persuasive as to why their idea explained everything. The media often love hedgehogs. “


The characteristics enabling one to appear on TV and become a famous pundit are not the same as the characteristics of being a successful trader or money manager.  Here is a passage from Future Babble on how to be a successful pundit, as illustrated by the charismatic overpopulation doomsdayer Paul Ehrlich:

“Be articulate, enthusiastic, and authoritative.  Be likable.  See things through a single analytical lens and craft an explanatory story that is simple, clear, conclusive, and compelling.  Do not doubt yourself.  Do not acknowledge mistakes.  And never, ever say, “I don’t know.”

People unsure about the future want to hear from confident experts who tell a good story, and Paul Ehrlich was among the very best.  The fact that his predictions were mostly wrong didn’t change that in the slightest.”

Now notice the difference in thinking with one of the greatest hedge fund managers ever, George Soros, “I think that my conceptual framework, which basically emphasizes the importance of misconceptions, makes me extremely critical of my own decisions.”  I know that I am bound to be wrong, and therefore more likely to correct my own mistakes.”

Most of the greatest traders and money managers I know think in terms of all sorts of possibilities and probabilities of various scenarios.

Likewise, this follows in line with the old Maynard Keynes expression, “When the facts change I change my mind.   What do you do sir?”

Indeed, the title of one of my favorite investment books is “Being Right or Making Money” by Ned Davis.  The title alone summarizes almost everything an investor needs to know about investing – do you care more about being correct, or do you care more about increasing your wealth?

Additional Reading

Being Wrong: Adventures in the Margin of Error by Kathryn Schultz

Why We Make Mistakes: How We Look Without Seeing, Forget Things in Seconds, and Are All Pretty Sure We Are Way Above Average by Joseph Hallinan

Mistakes Were Made (But Not by Me): Why We Justify Foolish Beliefs, Bad Decisions, and Hurtful Acts by Carol Tavris and Elliot Aronson

How We Know What Isn’t So: The Fallibility of Human Reason in Everyday Life by Cornell psychologist Thomas Gilovich

Expert Political Judgment:  How Good Is It?  How Can We Know?  By Philip Tetlock