Searching for a Better Investment Guru

U.S. stocks declined yesterday to the lowest prices in more than 12 years. The Standard and Poor’s 500 closed at 700. You would think that now would be a very good time to have a reliable investment guru offer sage advice and words of wisdom. Times are tough, the economy is tanking and there is panic in the streets (Wall Street and Main Street, both). What is an investor to do? Should she buy, sell, hold? “Surely,” you think, “the ‘experts’ must know.” Unfortunately, you’d be thinking wrong; the correct answer is that he or she really doesn’t.

Last month, in an article titled Why the Experts Missed the Crash, Money Magazine published an interview with UC Berkeley Haas Business School professor Philip Tetlock. The professor has spent his career evaluating experts and authorities in a variety of fields, and he is not at all surprised that the vast majority of financial “gurus” failed to predict the recent steep market decline.

Here is a summary of the article:

Despite everything, we can’t shake the belief that elite forecasters know better than the rest of us what the future holds.

The record, unfortunately, proves no such thing. And no one knows that record better than Philip Tetlock, 54, a professor of organizational behavior at the Haas Business School at the University of California-Berkeley. Tetlock is the world’s top expert on, well, top experts. Some 25 years ago, he began an experiment to quantify the forecasting skill of political experts.

Tetlock has analyzed “not just what the experts said but how they thought: how quickly they embraced contrary evidence, for example, or reacted when they were wrong. And wrong they usually were, barely beating out a random forecast generator.”

Why did so many experts miss the economic crash?

The people intimately involved in packaging [financial derivatives like] CDOs must have had some sense that they were unstable. But their superiors seem to have been lulled into complacency, partly because they were making a lot of money very fast and had no motivation to look closer. So greed played a role.

But hubris may have played a bigger one. … In this case the biggest source of hubris was the mathematical models that claimed you could turn iffy loans into investment-grade securities. The models rested on a misplaced faith in the law of large numbers and on wildly miscalculated estimates of the likelihood of a national collapse in real estate. But mathematics has a certain mystique. People get intimidated by it, and no one challenged the models.

Money has written about human mental quirks that lead ordinary folks to make investing mistakes. Do the same lapses affect experts’ judgment?

Of course. Like all of us, experts go wrong when they try to fit simple models to complex situations. (“It’s the Great Depression all over again!”) They go wrong when they leap to judgment or are too slow to change their minds in the face of contrary evidence.

An Alternative to Finding a Better Forecaster

A good part of the article explores the question “What makes some forecasters better than others?” Professor Tetlock has a detailed answer, which makes interesting reading. He recommends looking for “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.”

But my answer to the same question is radically different. I believe that it is futile to rely on gurus who have been right more often than others. Various “experts” will be right or wrong at different times, and you cannot, regrettably, know in advance when that will be. So if in essence, the future is unknowable, and experts are so unreliable, you need to have a strategy that does not depend on “accurate” forecasts.

No one, yes no one, knows how markets will behave in the short term. Accordingly, my recommended approach has been and continues to be a disciplined long-term strategy. To understand why, it is absolutely necessary to have perspective on financial history:

• There have been many financial crises in the past; none have proven fatal.
• We have experienced a dozen other Bear Markets since World War II.
• Stock prices have rebounded from all previous declines, even steep ones.
• The stock market goes up in roughly 3 out of every 4 years.
• Stock market losses are temporary; stock market gains are permanent.

Furthermore, waiting for the “right time” to invest doesn’t work for most people, most of the time. The likelihood is that you will miss out on the really strong rebounds that happen when you least expect them. In other words, don’t wait until it looks safe to invest in stocks.

Accordingly, I leave forecasting to the “experts” who according to Professor Tetloc “barely beat random guesses – the statistical equivalent of a dart-throwing chimp – and proved no better than predictions of reasonably well-read nonexperts.”

I do believe in controlling what I can:

• Costs (through low cost mutual funds)
• Risk (through global diversification and sensible asset allocation).

I believe in staying the course so as to participate in the eventual and inevitable recovery.

In short, I do not have a forecast; I have a philosophy and an approach. It’s not perfect, nothing in this world is, but experience shows that it works better than any other approach.