How Forecasts Influence Your Investment Decisions
We are just a few weeks away from “prediction season” for 2016. A time when pundits and experts will provide their best market and economic forecast for the future. Before you get too excited, it is important to realize that forecasters don’t have a good accuracy rating regardless of whether they are forecasting GDP, market performance or interest rates. Numerous studies have found their overall accuracy is the same as a coin toss, 50/50. A few things to consider when evaluating forecasts:
1. Forecasts tend to predict recessions that never occur and fail to predict recessions that do occur.
2. Hindsight – realizing how one thing caused another in the past, can make the future appear more predictable.
3. We are psychologically prone to be influenced by forecasts because they provide a false sense of certainty – even though we may acknowledge forecasts are seldom correct.
4. Most forecasts are extrapolations of what just happened and provide little to no value when considering future investment decisions.
Predicting The Next Black Swan
If a prediction is made that market participants view as possible with a given degree of probability, it will be quickly reflected in market prices. It is not a black swan because we know about it and have priced in its potential occurrence. On the flip side, if a prediction is made that appears unrealistic, it will be dismissed as “crazy”, “impossible” and be ignored by market participants. This could be an accurate prediction of a black swan event, but it would do us no good because we have ignored it.
By definition the market will never expect or be prepared for a specific black swan event. The event itself must be unexpected in order for it to be a black swan. Yet we tend to spend a lot of time and effort trying to identify the next crisis.
Spend Your Energy on What You Know and What You Can Control
Here are things we know:
1. Experts will continue to forecast the future, but will not be very accurate. Their high degree of confidence may influence us anyway.
2. Forecasts are generally useless to the investor and can be detrimental if you allow forecasts to influence your investment decisions.
3. We cannot (nor can experts) predict the next black swan event. No matter how much we would like to.
4. We know that at some point a crisis will occur. We may not be able to identify what causes it, when it will occur or how bad it will be until afterwards. Only then will it become obvious.
Since we know that at some point a crisis will occur, it may be more productive to consider how we will react to an “unexpected event”. The event itself may be unexpected, but we should certainly expect something unexpected will happen at some point. That is the nature of the markets. How will you respond?
This is at the heart of a good investment plan. Many investors react emotionally to unexpected events. That is because they have not previously thought about what they would do if the unexpected happens. But we know the unexpected will happen. So what will you do? You have no control over what the markets do, but complete control over how you will respond.
It may not be a bad time to not only consider these things, but put a pen to paper and start writing your investment plan down. The more specific and well-thought it is, the better chance you will have to overcome the emotional impulses to do the wrong thing at the wrong time.