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Beware the Sirens’ Call of short-term forecasts

by | Investments, Markets

Joe Wiggins recently asked over at behaviouralinvestment.com why it is that we all have such a fascination with short-term* forecasts of what a stock or market index may do.

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What is short-term*?

It is difficult to precisely define what short-term is, but the shorter the horizon and the greater the specificity in a forecast the more problematic it is likely to be.

Forecasting that equity returns will be positive on a twenty-year view, is an entirely different proposition to predicting how the Chinese A-Share market index might perform over the next six months.

Anything inside one year is incontrovertibly very short-term.

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Based on the totality of past experience, we can be pretty certain that:

  • Most people are terrible at making short-term market forecasts
  • It is not reasonable to expect people to be good at making short-term market forecasts
  • Acting on short-term market forecasts can have major consequences
  • Market forecasts encourage poor behaviours

Markets constantly remind us that attempting to forecast an inherently complex system is a fool’s errand yet, despite this, we cannot seem to resist it.

Why do we keep making and listening to short-term forecasts?

Our willingness to ignore the incontrovertible truth about (the unreliability of) market forecasts is driven by a range of factors from our own behavioural limitations to the structure of the asset management industry:

  • Overconfidence: Engaging in forecasting is a perfect example of how overconfidence can influence our behaviour.
  • Hindsight bias: Once something has happened, we cannot help but view it as an inevitable outcome. As everything becomes obvious after the fact, it feels like it was eminently predictable before it. Of course, it is not.
  • Incentives: Professional investors are incentivised to forecast market movements. Fees and careers depend on it. Giving clients the belief or sense that market, political and economic developments can be confidently predicted is an incredibly attractive sales pitch (even if it is an empty one).
  • Fooled by randomness: If we have a large group of people making market forecasts then inevitably there will be some who are correct. The mistake we make is to assume that certain individuals can consistently make good predictions through time.
  • False Expectations: There is an expectation that investors should have an opinion about ‘markets’ and saying “we don’t know” is incredibly difficult to do (and generally not a good career move).
  • Comfort: It is difficult living and investing in an uncertain world. Forecasts about the future give us comfort amidst chaos and unpredictability. Even though they are likely to be inaccurate, at the time they are made they make us feel better. [I call this false comfort the Delusion of Control {MJC}].

Instead of trying to make and listen to short-term forecasts, what should we do?

The lesson that we should learn (but never do) is that short-term movements in financial markets (and everything related to them) are far too difficult to accurately predict, and we should stop attempting to do it.

We need to make our investment decisions on the basis that over the short-term, we cannot forecast most things, not that we can.

It is possible to manage risks over shorter periods, and one’s investment horizon for each goal is crucial to constructing portfolios that are appropriate for that goal. Once that portfolio has been constructed then focus on the end of the period, not what may (or may not) happen tomorrow, next week, next month or over the next year.

Thinking long term will enable you to have better behaviours, make fewer mistakes and have better outcomes.

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* In Greek mythology, the Sirens were dangerous creatures who lured nearby sailors with their enchanting music and singing voices to shipwreck on the rocky coast of their island. In Homer’s epic poem Odyssey, the Greek king Odysseus had his crew put beeswax into their ears as they sailed past an island inhabited by Sirens so that they would not be lured by their beautiful sounds to the island and be wrecked there on the rocky coastline.

In modern writing, the Sirens’ Call has come to mean something that is very appealing and makes a person want to go somewhere or do something, but that may have bad results —often.