Prediction Addiction

Prediction Addiction

A COSTLY APPROACH

Earlier this year, Harry S. Dent Jr., advisor and author of The Great Depression Ahead, predicted stocks would start to plummet in June. He noted that personal spending is 70% of the economy and that, over time, as baby boomers become elderly, their personal spending will dive. The American economy, the advisor said, will fall off a cliff.

The man's comments seemed logical and rooted in common sense, and many investors seemed to buy his horror story. After the talk, several investors ostensibly decided to hunker down for bad times. (Does anyone remember the prediction that the markets wouldn’t be able to function as a result of crossing over from 1999 to 2000?)

Dent can be persuasive. In his new book, The Great Crash Ahead: Strategies for a World Turned Upside Down, he predicts the Dow will fall to as low as 3,000 by 2014.

History, though, shows a different story. Dent had also forecast the Dow to hit 40,000 in 2010. In 2009, he told people to get out of the stock market - just before the surge. The defunct AIM Dent Demographic mutual fund and the newer Dent ETF both badly underperformed the averages.

Persuasive as it sometimes sounds, investing based on these predictions has proven quite costly. And so it was for those who relied on the Wells Fargo chief economist, John Silvia, who boldly stated that rates would "definitely" rise last year. The January effect failed in 2011, as did what many claimed was the "always good" third year of the presidential cycle.

Some forecasts, though, are spot-on. Gary Shilling, president of A. Gary Shilling & Co. in Springfield, N.J., was one of the few economists who correctly foresaw the real estate bubble and recommended against owning stocks in late 2007. Shilling became infamous in 2009, however, when he predicted a down market and ended up being dead wrong.

The same goes with Meredith Whitney, the widely followed banking analyst who predicted the financial collapse in 2008, but was way off on massive municipal bond defaults in 2011. Following an expert who was prescient for one year can be extremely costly the following year.

WHY WE LISTEN TO FORECASTS

In Jason Zweig’s book, Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, finance writer Jason Zweig notes that there's a human compulsion to make forecasts, and calls such compulsion "prediction addiction". Zweig says that when it comes to investing, the pursuit of recognizing patterns in random data is a fundamental function of our brains. Though other animals have the ability to recognize patterns, humans are uniquely obsessive about it, says Zweig, who sits on the editorial board of the Journal of Behavioral Finance.

When it comes to investing, clients naturally search for order by finding patterns, and that order gives comfort. Unfortunately, we usually think we have discovered order where none actually exists.

Clients expect their financial planners to be studying economics and the markets, and they think they can rely on us to be experts in making order from the chaos of the markets. Many investors think they are paying us to bring this order to their portfolios, thinking we can predict when markets will surge or plummet, which asset classes will outperform next year, and which stock will become the next Apple.

Yet we don't bring order at all by making such predictions. For example, advisors under the TD Ameritrade platform had invested just 26% in cash and fixed income at the height of the stock market on Oct. 9, 2007, and 51% in cash and fixed income at the market bottom on March 9, 2009. In both cases, they were exactly wrong! By maintaining our strategic asset allocation for your long-term portfolios, we move the opposite way of the herd – buying when markets are low and selling when they are high. This is a recipe for making money… “buy low, sell high”.

UNCONSCIOUS AND AUTOMATIC

Breaking any addiction is a monumental task, and this particular one may be nearly impossible as it is part of our natural brain wiring. According to Zweig, our brains constantly leap to conclusions in an unconscious and automatic way.

To get a better picture of what goes on between our ears, conducting an MRI of the brain while thinking we are about to rake in a quick windfall looks like that of a drug addict about to get his or her next fix. Dopamine is the brain chemical that drives our prediction addiction. It's produced organically and is responsible for propelling our brain to take action to seek rewards.

When we get information, it's nearly irresistible to avoid taking action. Even knowing what we know about Dent and how his predictions have played out, we find ourselves sometimes naturally fighting our own reaction to sell assets, thinking that this time he may be right. When a client asks me what I think stocks will do for the rest of the year, I've found the best approach is not to compare such thoughts to those of a drug addict, but to educate the client on the subject of behavioral finance.

NOT KNOWING

To show the destructiveness of acting on predictions, a recent study of some mutual funds shows that investor returns badly lag the fund returns. Human nature seeks out what has performed well in the past and makes the seemingly logical conclusion that the same actions will lead again to a great performance. Next, fear sets in when the strong performance doesn't continue and we sell.

Carl Richards, author of The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money, writes that people will "repeat until broke". He says, "When people ask me to predict the future, I always just chuckle and say 'I have no idea.'" Most people, he says, know that we don't know and find it refreshing when we admit it. Our only “bet” is that the long-term trend is “up and to the right” as it has been through the Great Depression, the Great Recession, World Wars, the Crash of ’87, the Tech Wreck, et. al.

Advisor Rick Ferri, founder of Portfolio Solutions in Troy, Mich., offers an innovative answer to future seekers. During his quarterly conference call with clients, he walks them through the state of the economy, describing the implications of the predictions of economic indicators such as GDP, inflation and unemployment. He also tells clients how he thinks equities may perform in the short-term.

He lets every investor know, though, that his views have nothing to do with how he invests their money. The call helps clients who want to know the future without using market timing techniques that are likely to harm them. Yet, his firm relies on strategic asset allocation and rebalancing toward targets, just as we at Pauley Financial do.

While we can't predict the markets, we can predict something almost as valuable - human behavior. With near-perfect certainty we can predict that, if stocks go up over the next year, people will move into stock funds. And if they do poorly, people will pull money out. We tell clients that rebalancing is the one way to be a true contrarian. In investing, herds get slaughtered and true contrarians come out ahead.

Accepting that the future is uncertain can be a quite unnerving feeling. Education is the key to helping our clients accept and understand the inevitable uncertainty. Our investment approach is designed with no fallacies about being sooth-sayers. But we can apply discipline to avoid the ‘buy-high, sell-low’ herd mentality. In investing, knowing we don't know is one of the keys to avoiding herd behavior – and, thereby, increasing returns.