Let me first give you a little background, and then I'll explain why this need for market prognostication is so costly. Finally, I'll give you some thoughts on helping your clients accept uncertainty.
Author Jason Zweig notes in his new book, The Little Book of Safe Money, that research shows humans are addicted to making predictions. In an interview, Zweig says that "randomness is terrifying." Believing that we know what's going to happen next year, even if it's unknowable, brings us comfort. Thus, we bet on the future direction of the stock market by employing all sorts of complicated techniques, as well as paying a fortune to those who claim to know what the future holds. In addition, we use hindsight to explain the past, as if today's solutions to yesterday's conundrums had been obvious back then. We then extrapolate the past into the future.
To see an example of both, let's travel back in time to the beginning of 2008. We had just finished our fifth straight year of stock market gains, during which time the value of U.S. stocks had nearly doubled and that of international stocks had nearly tripled. A few people were issuing warnings about a real estate bubble, but most predictions were for more good times.
Then came the deluge. It's impossible to forget what actually happened in 2008, as real estate values collapsed, the term NINJA loans (no income, no job or assets) came into vogue and the credit markets froze up, almost bringing down the world financial system. It was obvious that lending money to people who couldn't pay it back was going to lead to disaster, right?
Though it may have been obvious in hindsight, it couldn't have been less obvious in 2007. Had people realized what was coming, the market wouldn't have peaked that year and the stocks of companies like Bank of America and Citigroup wouldn't have hit new highs.
HOW WE PREDICT THE FUTURE
The news is always full of experts telling us what the future holds, and the investing world is no different. How we predict the future, however, might surprise you.
On a biological level, the brain observes events and then models future expectations based on those events. That's all well and good, but many studies show that humans tend to estimate future probabilities based upon a handful of recent events, rather than on the basis of long-term events. This tendency is known as "recency bias."
To see examples of recency bias that caused investors to be overoptimistic, just go back to the years 2000 and 2007. Remember how we justified the continuing rise of the stock market based first on, "it's the New Age economy and cash flow doesn't matter," and later on, "real estate could never decline"? For a recent example of pessimistic recency bias, go back to March 2009, when many predicted that capitalism was dead and ready for burial-and along with it, Americans' retirement accounts.
The bottom line for recency bias is that neither good times nor bad times last forever, though we tend to believe they do.
Avoiding recency bias is critical, but still may not be helpful in predicting the stock market. At the end of 2007, economist Gary Schilling was not following the herd of more good times to come. He predicted that the housing bubble would burst and the stock market would go below 2002 levels. His logic was compelling and he was one of the few gurus who didn't use hindsight to explain why the market collapsed.
But getting it right one year doesn't make a trend. Schilling predicted that asset values would continue to fall throughout 2009, with the S&P 500 closing out the year between 500 and 600. So if you learned of his wisdom after the plunge and followed his advice in 2009, you would have missed out on the recovery: As of early December, the S&P 500 is at twice his predicted levels.
ASSET ALLOCATION IS ALIVE
Until the 2008 market plunge, it was widely believed that asset allocation reduced risk. I am among those who believe this is still true. William Bernstein, author of The Investor's Manifesto, noted in an interview that investors maintained unrealistic assumptions about the movement of various asset classes in relation to one another in the short run.
