The Follies of Fortune Telling

I grew up watching “60 Minutes” Sunday evenings, so like many people, I was saddened to hear of the death of commentator Andy Rooney last month. He was occasionally too curmudgeonly even for me, but he presided over the final minutes of a show that was a fixture in our household. One of my favorite segments aired a few years ago, when Rooney replayed bits from a 1986 CBS News series that previewed what life would be like in 2001. Experts predicted that the Russians would land on Mars, cars will be commanded by operator's voice, Americans would work just 30 hours a week, cows would be the size of elephants, and pigs would be five feet tall.

It hasn't quite turned out that way. Cows and pigs are still the size of cows and pigs, and my car doesn't respond to my voice — not even the expletives I shout in traffic. It's important at this time of year to remember how hard it is to predict the future, because soon we'll begin to see articles in media featuring various experts' guesses for what the stock market will do in 2012.

As evidence of the value of such forecasts, let's travel back to a Jan. 2, 2002 article in USA Today. The article featured the predictions of eight top Wall Street analysts and where they thought the S&P 500 would be at the end of 2002. The article began by pointing out that not one of the analysts polled a year earlier were right about 2001: Each had predicted a positive year for the S&P 500. Instead, it declined 13%. Did they do a better job in 2002? Nope. The average prediction was for an 11% gain. As you may recall, the S&P 500 declined more than 22% in 2002.

More recently, a BusinessWeek article published at the end of 2007 listed the predictions of six strategists of where the Dow would be at the end of 2008. The average guess was 14,925; by Dec. 31, 2008, the Dow had plummeted to 8,776.

Some prognosticators expected the Dow to be even higher. Back in March of 2008, Mark Hulbert — who has tracked the performance of hundreds of newsletters since 1980 — highlighted the prediction of Richard Band, whose newsletter's risk-adjusted return was “in the upper echelon of newsletters.” Band claimed that the market was forming “the ‘right shoulder' of a head-and-shoulders bottom,” and the Dow would reach 16,000 by late 2008 or early 2009. Instead, the Dow closed as low as 6,547 in March 2009.

My favorite prediction from 2008 came from a Wall Street Journal article that highlighted the views of Igor Panarin, a former KGB agent and the dean of the Russian Foreign Ministry's academy for future diplomats. Since 1998, he has propagated a theory that the United States would break up into six pieces in the summer of 2010, due to “mass immigration, economic decline, and moral degradation.” According to the article:

California will form the nucleus of what he calls “The Californian Republic,” and will be part of China or under Chinese influence. Texas will be the heart of “The Texas Republic,” a cluster of states that will go to Mexico or fall under Mexican influence. Washington, D.C., and New York will be part of an “Atlantic America” that may join the European Union. Canada will grab a group of Northern states Prof. Panarin calls “The Central North American Republic.” Hawaii, he suggests, will be a protectorate of Japan or China, and Alaska will be subsumed into Russia.

Alaska will be part of Russia? Has anyone told Sarah Palin?

Why we love predictions, and why we shouldn't
In September, the Freakonomics team (author Stephen Dubner and economist Steven Levitt) devoted an entire podcast to predictions. They interviewed Phil Tetlock, a research psychologist at the University of Pennsylvania. Tetlock says, “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.” This creates a desire — and market — for forecasters. But how good are these soothsayers?

Over the past 20 years, Tetlock has tracked approximately 80,000 predictions of 300 political experts. The result: Their predictions are only slightly more accurate than a sample of undergraduate students or random guessing, and slightly worse than “a computer programmed to predict ‘no change in current situation.'” Not very impressive.

The Freakonomics team also interviewed Christina Fang, a Professor of Management at NYU's business school. She co-authored a study of the Wall Street Journal's Survey of Economic Forecasts, which asks 50 economists about various macroeconomic numbers. According to Fang, the study found that “those people who correctly predicted either extremely good or extremely bad outcomes, [are] likely to have overall lower level of accuracy. In other words, they're doing poorer in general.”

This is important to keep in mind, since the people who get the most air time are the ones who make the most extreme predictions. As Levitt explained, “The incentives for prediction makers are to make either cataclysmic or utopian predictions, right? Because you don't get attention if I say that what's going to happen tomorrow is exactly as what's going to happen today… I don't get on TV.”

Your prediction-protection strategy
Okay, so no one knows what the stock market will do next year or even the next few years. There is evidence to suggest that overall market valuation provides a hint as to what to expect for the next seven to 10 years. That's helpful for retirement planning, since we can use that estimate in our financial calculations. But it doesn't help the market timer.

Of course, as investors we must make some assumptions about what the future will look like, since investing is all about buying something today that you think will be worth more — both in absolute terms as well as relative to other investments — years from now. Here's how to balance the need to make bets on the future without trying to do the impossible:

• Only pay attention to people who have a track record of being right about things that are possible to be right about. An expert stock picker or fund manager could possibly be skilled… or just lucky. Someone who correctly guesses where the Dow will be a year from now is definitely just lucky.
• Since the stock market can drop in any given year — despite what the “experts” predict — make sure you keep money you need in the next three to five years out of the market.
• Be aware of incentives. Is someone making a prediction that leads to buying a certain product or service she or he sells?
• Is the person dogmatic or ideological? Tetlock's research found that people with pre-set, rigid beliefs had the worst record.
• Invest at least a portion of your money according to the acknowledgement that you — or the advisers and managers you hire — could be wrong. In other words, stay diversified and invest at least some of your assets in index-based investments.
• Don't run your financial life in a manner that is dependent on just one outcome or on your life continuing on the same path uninterrupted. Always have a Plan B.

I have more to say about predictions, but I must get going. As a resident of the Washington, D.C., metropolitan area, I plan on converting my dollars into euros and preparing my campaign for president of “Atlantic America.”