Some clients think planners are soothsayers, able to see the future. And while the desire to predict the future is inherently human, it's usually destructive - particularly when it comes to investing.

 

A COSTLY APPROACH

Earlier this year I attended a talk by W. Michael Robertson, chairman of Robertson Wealth Management of Houston. Using slides from Harry S. Dent Jr., advisor and author of The Great Depression Ahead, Robertson, who's on the board of the Harry S. Dent Foundation Advisory Board, 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 I was interested if audience members were buying his horror story. Many were.

Nobody covered their eyes or squirmed in their seats, but the fear and anxiety generated from this gloomy prediction filled the room - they bought the premise. After the talk, several people told me they were going to sell and hunker down for bad times.

Dent can be persuasive, and every time I listen to him or one of his disciples, I'm inclined to act on his predictions. 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 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 been 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 much better known 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 his 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's on the editorial board of the Journal of Behavioral Finance.

I often invite college students when I teach to randomly imagine flipping a coin 25 times. Try this mental exercise and write down "H" for heads and "T" for tails a total of 25 times. You'll probably find yourself creating a pattern and, once discovered, you change it to break the pattern, only to quickly discover you are following yet a new pattern.

When it comes to investing, we act in the same manner. We search for order by finding patterns, and that order gives us comfort. Unfortunately, we usually think we have discovered order where no order 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.

On March 7 of last year, a Charles Schwab sentiment survey showed new optimism among financial advisors. Nearly 80% predicted the S&P 500 would rise in the next six months. It actually declined 11.8%.

 

UNCONSCIOUS AND AUTOMATIC

Breaking any addiction is a monumental task, and this particular one may be nearly impossible because it's 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 I know about Dent and how his predictions have played out, I fight my own reaction to sell stocks, 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.

Zweig suggests that planners try an exercise asking clients to write down predictions for the year-end values of such variables as the Dow, the best- and worst-performing stock sectors, interest rates, and the prices of gold and oil. While the client fills in the blanks, the planner simply writes down "I don't know" for each category. Then the predictions are exchanged. The predictions are then saved.

After the end of the year, the planner and clients should meet again to review the predictions. Almost without fail, the advisor's "I don't know" answer will look pretty intelligent by comparison to what the clients thought they knew.

 

NOT KNOWING

To show the destructiveness of acting on predictions, I explain my own study of some mutual funds, which show 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.

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. His firm relies on strategic asset allocation and rebalancing toward targets. The call helps clients who want to know the future without using the market timing that is likely to harm them.

I tell my clients that, while I can't predict the markets, I can predict something almost as valuable - human behavior. I can tell them with near-perfect certainty 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. I tell clients that rebalancing is the one way to be a true contrarian, and everyone loves to be a contrarian. That's because, in investing, herds get slaughtered and true contrarians come out ahead.

Accepting that the future is uncertain can be a very lonely feeling. Getting our clients to accept that uncertainty, with the understanding that we don't know how markets will perform, isn't easy. In investing, knowing we don't know is one of the keys to avoiding herd behavior - and increasing returns.

 

 

Allan S. Roth, founder of the planning firm Wealth Logic in Colorado Springs, Colo., writes the Irrational Investor column for CBS MoneyWatch.com. He is an adjunct faculty member at the University of Denver.