10 
10 NEARLY EVERY STUDY OF FORECASTING IN ECONOMICS AND FINANCE shows that we human beings are poor predictors of the future. Much of what passes for analysis on Wall Street is really just veiled, half-formed forecasts about the future. As Barry Ritholtz writes: “I wish an SEC-mandated disclosure accompanied all pundit forecasts: ‘The undersigned states that he has no idea what’s going to happen in the future, and hereby declares that this prediction is merely a wildly unsupported speculation.’ ”1 Given our collective inability to forecast the future, why do we all persist in doing so?
Some believe like Philip Tetlock, who wrote a notable book on the topic of forecasting and prediction, that we humans have an innate need to feel that the world around us is in some fashion predictable.2 Tetlock states: “There are a lot of psychologists who believe that there is a hard-wired human need to believe that we live in a fundamentally predictable and controllable universe. There’s also a widespread belief among psychologists that people try hard to impose causal order on the world around them, even when those phenomena are random.”3
It is because we humans hate randomness that many investors have a weakness for pundits with strongly held opinions about the future. The markets often feel like they are a messy, paradoxical place. A singular vision about where the markets are headed, even if it is of dubious value, feeds our need for a more predictable world. Investors can get especially sucked in when a market pundit actually gets a big market call correct.
Analysts who correctly called the market crash of 1987 have been living off that call ever since then. The irony is that research shows that those forecasters who get these “big calls” correct turn out to have the worst overall track records. Denrell and Fang show that this has to do in part with how forecasters take into account the full range of available information.4 The trouble is that those forecasters who often take a more measured, probabilistic approach do not feed our need for certainty.
As James Montier notes, the problem is that the worst forecasters are oftentimes the most overconfident.5 Overconfidence is a finding well documented in psychology and behavioral finance, based on the fact that people are routinely surprised by future outcomes. We humans have a persistent belief in our own skills, or that we are above average. Montier also notes that when forecasters are confronted with their erroneous forecasts, they are likely to choose from a list of excuses to avoid having to face up to their failures. Overconfidence is a prime driver of many ill-suited investing behaviors in part because it does not require us to be humble in the face of our own shortcomings.
There are better ways to forecast than to follow the advice of a handful of economists who are doing little more than spinning stories about historical results. Focusing on real-world indicators is a better approach. Earlier in the book, we saw how a simple economic forecasting model based on the slope of the yield curve outperformed economists’ predictions. By focusing on indicators that take their cue from real-world decision makers, like the various purchasing manager indexes, we can do a much better job than the chattering classes.6
If forecasting the future is largely a waste of time, what should investors do? One approach is to spend more time preparing for unfavorable scenarios. We live a world that is generating all manner of surprises, both man-made and natural. Identifying those major risks and their potential costs is a big first step in creating a forecast-free approach to investing. This requires us to let go of the illusion that we can forecast the future and embrace a wider range of potential future outcomes.
We have already seen that stock and bond markets can go down and stay down longer than commonly believed. Investors should take into account scenarios in which the financial markets do not provide positive returns, but in fact generate negative returns. This kind of contingency planning focuses on the downside risks and lets the upside take care of itself. Above all, it meets our goal to move our portfolios, largely intact, from one period to the next.
As we have discussed, strategies like broad diversification and indexed investing have merit in part because they do not rely on forecasts. These strategies recognize our inability to predict with any great precision what certain asset classes or stocks are going to do. By saying “I don’t know” to the question of future returns and by diversifying widely and indexing, investors follow a broad-brush approach to investing, capturing capital markets returns in an unbiased way.
The two main investment strategies discussed, value and momentum investing, do not use forecasts as a part of the process. Momentum investing is explicitly backward looking in that it uses past returns as a tool to rank potential investments; the only assumption is that recent past returns tend to persist. Value investing and the search for a margin of safety are necessarily backward looking. Value investors focus on the disparity between the current price of the stock and the true underlying value of the company. Because value and momentum investing both require analyzing the present much more than the future, they avoid the forecasting fallacy. In so doing, these two approaches to active investing are likely to be more consistent and sustainable.
The “prediction addiction,” as Jason Zweig calls it, is a strong one.7 We can, as Zweig suggests, take steps to restrict our ability to tinker with our portfolios, like setting up automatic investment plans. We can also try and test our ideas in a systematic fashion before we put them at risk in the market. Zweig notes how paper trading can be a way to test our capabilities in a lower-risk setting. More often than not, we will find that our ideas are not all that great in practice.
This idea of getting our portfolios largely intact from one time period to the next goes hand in hand with the need to avoid the folly of forecasting. A focus on the risks we face is far more important than making some one-time market call. It is not for nothing that Abnormal Returns has as its subtitle A Forecast-Free Investment Blog.
Track records are the stuff of which Wall Street careers are made. The first thing potential investors want to know about a fund before they invest is the fund’s past performance. Some managers have made careers off one or two good years of performance. Investors flock to hot performers despite the fact that the admonition “Past performance is not indicative of future results” appears on nearly every piece of fund marketing material. The truth is that in many cases we simply don’t have much more in the way of information than past performance. The whole idea of active investment management revolves around the idea of identifying and paying for skilled managers. Nobody wants to pay a manager whose results are based solely on luck.
It is therefore difficult to distinguish the degree to which skill and luck play a role in investor performance. First, we should recognize that investing is a field in which both skill and luck do play a role. Investing is often compared to gambling and most often to poker, and for good reason. There is no doubt that chance, or the cards drawn, plays a role in poker outcomes. Recent research also shows, contrary to what the authorities say, that poker on the whole is a game of skill.8 Unfortunately for investors, our ability to identify skilled investment managers is much more difficult than identifying skilled poker players.
Some argue that finding skill in the world of professional investors like mutual fund managers is like finding a needle in a haystack. Fama and French examine the performance of mutual fund managers and find that before expenses the top 5% or so of managers demonstrate some skill compared with chance.9 The performance picture worsens dramatically once you take into account expenses, which largely wipe out the benefit of skill in the best managers. You can guess what it does for the rest of the mutual fund manager crowd. Anyone looking for skilled managers needs to recognize that identifying skill isn’t enough. The challenge is identifying managers whose skill outweighs whatever fees they charge investors.
There is reason to believe that it has become more difficult over time to beat the market. There is little doubt that the investment management industry has become more sophisticated and professional over time. This professionalization also explains why it is so hard for fund managers to beat the market. This phenomenon is what Michael Mauboussin calls the “paradox of skill.” Mauboussin writes: “The paradox of skill is one reason it is so hard to beat the market. Everybody is smart, has incredible technology, and the government has worked to ensure that the dissemination of information is uniform. So information gets priced into stocks quickly and it’s very difficult to find mispricing. By the way, the standard deviation of mutual fund returns has been declining for the last 50 years or so, just as it has for batting averages.”10
Just like in baseball, investing is awash in statistics. Unfortunately for investors, in most cases we simply don’t have enough data to say with any statistical confidence whether a manager’s performance was due to skill as opposed to luck. Baseball players get hundreds of at-bats in a single season. Investment managers need to be around nine years, using monthly returns, just to generate a hundred observations. As Aswath Damodaran writes, “One problem that we face in portfolio management and corporate finance is that we get to observe outcomes too infrequently, making it difficult to separate luck from skill.”11
One measure that is appealing in its simplicity is streaks. Andrew Mauboussin and Samuel Arbesman demonstrate that streaks in fund performance indicate the existence of differential skill.12 Streaks, and the consistency they imply, are a measure that appeals to our intuition. As any baseball fan knows, there is nothing more frustrating than a skilled but inconsistent baseball player. Streaks can occur in part by chance, but the existence of streaks can help investors distinguish among managers.
Just as the existence of streaks indicates skill, the existence of luck implies mean reversion. Mean reversion simply means that lucky streaks come to an end. There are few corners of the investing world that are not touched by mean reversion. Michael Mauboussin writes: “Importantly, reversion to the mean in the investment business extends well beyond the results for mutual funds. It applies to classifications within the market (small capitalization versus large capitalization, or value versus growth), across asset classes (bonds versus stocks) and spans geographic boundaries (U.S. versus non-U.S.). There are few corners of the investment business where reversion to the mean does not hold sway.”13 Given the importance of mean reversion, you would think that investors would be acutely aware of its role when making decisions. Research shows that investors overreact to recent performance, often to their own detriment.
One way in which investors can tamp down on their desire to overreact to recent performance is to become more informed, and comfortable, with an investor’s investment philosophy and performance. Transparency plays a big role. Managers who are willing and able to communicate a clear investment process give investors some small comfort that the process is reproducible over time. As well, managers who are willing to acknowledge that luck plays an important role show that they recognize that the world of investing is a challenging place for even the most skilled.
In the end, we all need to be comfortable with our own investment decision making and to trust that a careful approach will yield positive results over time. Howard Marks says it well: “In the long run, there’s no reasonable alternative to believing that good decisions will lead to investment profits. In the short run, however, we must be stoic when they don’t.”14 We live in a world filled with randomness, and recognizing this is an important step in dealing with our investments in a more measured and mature fashion.
We have seen that one reason why investors think it is easy to beat the market is that they don’t recognize that both skill and luck play a role in investor performance. Another reason that investors believe they can beat the market is that they ignore evidence to the contrary. This issue is not limited to when we are dealing with investments but is a persistent mental model we access all the time. Simply put, “The confirmation bias is the tendency to seek information that confirms prior conclusions and to ignore evidence to the contrary.”15
Confirmation bias is a persistent feature of the financial markets. All underperforming fund managers will point to the performance figures that put themselves in the best light. This is the case with individual investors as well. Earlier we discussed the necessity of keeping accurate records when tracking our own investment performance. This is important because as Meir Statman writes: “Investors who believe they can pick winning stocks are regularly oblivious to their losing record, recording wins as evidence confirming their stock-picking skills but neglecting to record losses as disconfirming evidence.”16 When it comes to our own skills, we are more than happy to delude ourselves by ignoring the hard truths.
It’s not hard to see how our desire to focus on information that confirms our already existing beliefs could be a liability when it comes to investing. The fact is that even the very best investors are wrong a lot of the time. In a previous chapter, we saw that it is possible to be wrong most of the time but still be a profitable trader. Successful investors recognize that it is not a sin to be wrong, but it is a sin to stay wrong. Every trader will tell you that cutting your losses is the key to surviving in the markets. It doesn’t matter why you are wrong, but recognizing you are wrong will save you from portfolio-killing events such as riding a favorite stock all the way down into bankruptcy.
The question is why are we stuck with this mental model that makes us so willing to overlook a broader reality. Michael Mauboussin notes how confirmation bias is really all about keeping the external world consistent with our own version of the world.17 Constantly questioning every idea we hold with new data and information would not only be time consuming but also exhausting. Confirmation bias allows us to stop thinking about an issue and relieves us from the need to act or react. We humans simply don’t have enough mental bandwidth to be constantly testing our core beliefs.
Not only is confirmation bias a flaw in the way we process information; it is also present in the way we take in information. With confirmation bias at work, we perceive information in a selective fashion. On one level, we make conscious decisions on what information to take in: we watch Fox News or MSNBC; we read the Wall Street Journal or the New York Times. On a subconscious level, we simply never perceive information that may not fit with our worldview. While the selective intake of information is dangerous enough, our increasingly electronic search for information can lead us astray.
With so much of information coming from online sources, we need to be aware of the ways that confirmation bias can happen without any action on our part. Eli Pariser in The Filter Bubble highlights the many ways in which online information providers tailor the things we see based on some profile they have of us. In some ways, this predictive search can be helpful. When we search for a pizza place, it is helpful to know where we are so as to generate geographically relevant results. The ultimate goal of this online profiling isn’t necessarily to best inform us; rather it is designed to get us to click or interact with the site in question. As Pariser writes: “The filter bubble tends to dramatically amplify confirmation bias—in a way it’s designed to. Consuming information that conforms to our ideas of the world is easy and pleasurable; consuming information that challenges us to think in new ways or question our assumptions is frustrating and difficult.”18
Given all the internal and external forces working against us as investors, it is imperative that we work to try and offset the effects of confirmation bias. In a sense, we need to constantly be asking, “Tell me something I don’t already know”—because there is a good chance the markets already know it. There are three ways in which we can try and work against confirmation bias.
The first is to be conscious of the risks of the filter bubble. Personalization on the Internet is a feature and not a bug. Pariser notes the best thing we can do is try to get outside our comfort zone and visit sites that stretch our thinking. A conscious effort to expand our influences can go a long way in opening up different ways of thinking.
Second, we need to actively search out discomfiting evidence. If we have a strong belief about a company, we need to consciously seek out evidence that is at odds with our view. This is admittedly hard work, but it is a necessary antidote to confirmation bias.
The third way is to expose our ideas to others. On the face of it, confirmation bias shouldn’t exist. It is not a helpful adaptation. However, the argumentative theory posits that we have confirmation bias because it makes us more effective advocates for a position. That is why the first two remedies we recommend to combat confirmation bias may be of limited use. Hugo Mercier states: “On the other hand, when people are able to discuss their ideas with other people who disagree with them, then the confirmation biases of the different participants will balance each other out, and the group will be able to focus on the best solution. Thus, reasoning works much better in groups.”19
We humans are beset with all types of biases, some that are helpful, some that are benign, and some, like the confirmation bias, that can be harmful at times. The best investors recognize that they are likely to be wrong on a pretty frequent basis and take steps to minimize the harm that comes when errors occur. The worst situation for investors to be in is to be wrong and not have the tools to turn their thinking around.
If you were offered a way to increase your returns while lowering your risk, you would think it was some sort of cheap ploy. There are very few free lunches in the markets, but there is a very simple way to generate better risk-adjusted returns. Invest more like a woman. For the 51% percent of you who are women, this should be pretty easy. For the other 49% who professionally manage the vast majority of funds, it might be a more daunting task.
You wouldn’t think this gender balance was the case when you look at the financial services industry in general and the money management business in particular. But even a cursory glance at the boardrooms or trading floors would show a lack of women. The numbers bear this out as well. Recent surveys show that women manage only 10% of mutual funds and only 3% of hedge funds.20 Some argue that the evidence points toward a prejudice against females in finance.21 No matter how you parse the data, this seems like a market failure.
This disparity is all the more confounding when research shows that women generate returns that are equal to if not greater than what men achieve. One study showed male fund managers trading more aggressively and not sticking to their investment mandate. However, this activity didn’t translate into higher risk-adjusted returns for male managers.22 According to these results, a female-managed fund is more likely to play nicely with other funds in a portfolio.
The danger of overconfidence and its impact on investing is a recurring theme throughout this book. Overconfidence manifests itself in overaggressive trading. A now classic study by Barber and Odean documented that men trade more than women, thereby reducing their returns.23 This effect is even more pronounced among single men. Therefore, if men took a less frenetic approach toward investing, they could likely generate higher returns.
Taking a more measured approach may be more important in difficult markets. An index of hedge funds of which half were female-run outperformed dramatically a broader index of hedge funds in the turbulent market year of 2008.24 This performance led in part to this conclusion: “The tendency of many women investment managers to be more patient and consistent, as well as their tendency to examine more conflicting data when making investment decisions, adds a moderating effect to highly turbulent markets and may be especially significant during market downturns.”25
Maybe we shouldn’t be so hard on men. It may simply be the case that their biology is working against them in some very fundamental ways. Research has shown a link between testosterone levels and risk taking. From a trading perspective, one could see how a little testosterone could help a trader. However, an overabundance of testosterone, which shows up after a series of winning trades, could lead to overly risky trades.26 Another hormone-related effect is evident as well. Cortisol levels, which are associated with stress, show up during periods of market volatility. Over long periods of time, it seems that elevated cortisol levels can have real, negative effects on health and mood.
If you extrapolate this behavior to the markets as a whole, you could see how it could generate bull and bear markets. Researcher John Coates stated: “Maybe bubbles and crashes are coming from these steroids … maybe if more women and older men were trading, the markets would be more stable.”27
We certainly can’t legislate who trades in the markets or whom people hire to manage their money. The issue of gender equity in the financial services industry is beyond the scope of this discussion. However, we can highlight the ways in which female investors excel so that you can try to apply those ideas to your investment approach.
One author argues that female investors have a great deal in common with the way that Warren Buffett invests. LouAnn Lofton notes eight ways that the typical approach of female investors jibes with Warren Buffett’s. She notes that female investors are more realistic in their investment expectations than men. Lofton also notes that women “put in more time and effort researching possible investments, considering every angle and detail, as well as considering alternate points of view.”28
It is easy to get locked in to thinking about investments in a certain way. The important takeaway is that all investors, male and female, need to challenge themselves. Just as men are more prone to overconfidence, women are more likely to “consider every angle” in regard to an investment, which could very well lead to analysis paralysis. We are all flawed and filled with a range of biases. The challenge for men and women is to acknowledge these biases and try our best to combat them.
That being said, men probably have the most to gain from this sort of exercise. Jason Zweig’s advice to men probably sums things up best: “Memo to men: Your household’s investment portfolio will be less risky and more diversified if your wife helps manage it. She will share in what comes out of that portfolio down the road; shouldn’t she share in what goes in to it? Chances are, her ideas and emotions will complement yours, and you will both end up wealthier. At least one of you will end up wiser.”29
Despite the many ways that investing has become easier and cheaper over time, it is still an area filled with complexity. As Lusardi and Mitchell write, “A larger array of available financial instruments does offer new opportunities for more tailored financial plans than available in the past, but these can also make poor decision-making more costly to the ill-informed investors.”30 The great thing is that your financial needs are likely not all that unique.
We have talked about some of the parts of a financial plan, including asset allocation, portfolio management, and investing in general. Any comprehensive personal financial plan would include not only investing, but also retirement planning, income taxes, insurance, and estate planning. No one is an expert in all these fields, and every one of them comes with its own costs and benefits. Unfortunately we are largely left to our own devices to navigate these fields.
Most people recognize that a do-it-yourself approach in all these areas is not realistic. Therefore, hiring qualified professionals to put together an estate plan or to counsel you in regard to insurance coverage seems like a prudent thing to do. The only thing worse is not undertaking those activities that serve to protect you and your family.
It is controversial to be against something as seemingly valuable as financial literacy, but this education does come with a cost. A paradoxical effect of financial literacy education is that it can create worse outcomes. Willis writes: “In reality, this education may do no more than increase overoptimism and the illusion of being able to control financial risks. Participants consistently self-assess as having learned a great deal and having gained confidence, but their poor performance on literacy exams indicates that their confidence is misplaced.”31 In short, participants do not really know what they think they know.
A worse sin that we all face is that we do not know what we do not know. We are all at risk of making decisions based not on faulty information but on a lack of knowledge of the issues at hand. For example, a majority of workers eligible for defined pension plans don’t have much knowledge about what benefits they are eligible for.32 We should all recognize the specialized areas in which we likely do not have enough knowledge or education to make decisions. In talking about investment education, it may seem an anathema to say that in many cases individuals would be better off with investment counsel than they would be doing it on their own.
The challenge comes not necessarily in education, although as we have seen, that could a problem. The investor’s challenge comes down more to the issues of behavior. We know that one of the behaviors that can be detrimental to an investor is overtrading. While the explicit costs of trading these days are low, the implicit costs remain high. These costs are high because overtrading usually involves trades that occur emotionally rather than as a result of a rational calculation. In short, we buy high and sell low on a consistent basis.
One could think of all sorts of ways of preventing this type of behavior, but in the age of the online brokerage account, a potential trade is only a few mouse clicks away. One way of removing the temptation to click is to interject another party between you and your portfolio. This usually takes the form of some sort of financial advisor or investment manager.
No one who has looked at the evidence should expect to get consistently market-beating results by hiring an investment manager. Maymin and Fisher note that, given this middling performance, individuals who hire managers may be looking to them to serve some other function. They write, “Perhaps investors retain advisors to prevent themselves from making bad trading decisions—to help them navigate near-term emotions like fear, regret, and greed and make healthier, more-objective choices that keep them on track to meet their long-term goals.”33
By tracking the “touches” an advisory firm had with its clients, Maymin and Fisher are able to demonstrate that individuals act consistently with this sort of approach. Clients eventually become more relaxed in their contacts with the firm. Not surprisingly, they become anxious in times of market volatility and seek out their advisor more often. So the value added in these client-advisor relationships comes not through the underlying performance of the portfolio but through the support of an advisor who acts as an emotional buffer. Maymin and Fisher write, “Therefore, we conclude that the advisor’s role in helping investors stay disciplined and on plan in the face of market volatility, including dissuading them from excessive trading, is one that is highly valued by the individual investor.”34
One of the challenges for investors is to find an investment advisor who can act in this capacity. The sexy part of the investment management business is in some of the areas we have already discussed—selecting securities, allocating assets, and managing portfolios. This is the ongoing challenge of “beating the market.” These things have tangible outcomes that can be measured and monitored.
Yet this may be a misplaced effort. Charles D. Ellis, author of the investment classic The Winner’s Curse, notes how clients would be better served by a focus on investment counsel as opposed to even more intensive investment management. He writes, “Our profession’s clients and practitioners would all benefit if we devoted less energy to attempting to ‘win’ the loser’s game of beating the market and more skill, knowledge, and time to helping clients recognize market realities, understand themselves as investors, and clarify their realistic objectives and then stay the course that is best for each of them.”35
Ellis notes that this is easier said than done, in part because this requires a different skill set and mindset than that required for investment management. The point is a good one though. Putting together a globally diversified portfolio of index funds is now cheaper and easier than ever before. It should not be surprising that we are seeing new online services that want to manage your portfolio for a fee far less than what is commonly available from investment advisors. The difficulty does not lie in constructing the portfolio but rather in managing our inevitable reactions to its ups and downs.
Going further, financial advisors are in a prime position to help individuals make more informed choices about their financial future that have little or nothing to do with portfolio management. In commenting on the financial services industry, Dan Ariely writes, “It’s still centered on the rather facile service of balancing portfolios, probably because that’s a lot easier to do than to help someone understand what’s worthwhile and how to use their money to maximize their current and long-term happiness.”36 These types of decisions are tougher and ultimately more important than the nuances of today’s portfolio allocation. Unfortunately the vast majority of people in the financial services industry are not set up to provide this type of service.
Nothing in this discussion means you should, or should not, hire someone to manage your portfolio. Research shows that even when presented with an opportunity to receive free, unbiased investment advice, the vast majority of investors decline the offer. And those that do accept the offer don’t follow through on the advice.37 So we should not be complacent that availability of financial counsel is some sort of magic bullet. Some investors are competent in handling their finances. Others will never get comfortable handing the reins over to someone else. No matter the circumstances, we all need some strategy or structure to help buffer our portfolios from our worst instincts.
For some, that means hiring an advisor. For others, it may mean having some other trusted individual, perhaps a spouse or colleague, with whom they can discuss these matters. And still for others, it may involve using simple coping strategies that prevent them from making rash decisions in regard to their portfolio. It seems strange to talk about not going it alone in a book on becoming a more informed investor. The fact is that none of us have all the answers. We all need help in trying to make sense of an increasingly complex and noisy financial world.
Despite a poor track record we humans are addicted to forecasting. Investment strategies based on accurate forecasting are likely doomed to underperformance.
Investing is an arena in which both skill and luck play a role. Investors should seek managers who are transparent about their strategies and humble in their approaches.
Confirmation bias prevents us from finding disconfirming evidence. Investors need to work actively to expose themselves to a wide range of information.
Male investors would do well to take some cues from female investors, who achieve equal returns with less risk and less trading.
No individual can be competent in all areas of personal finance. We all need some help and counsel, especially when it comes to avoiding rash decisions.
True financial planning is less about portfolio management and more about the major financial dilemmas we all face.