From the Archives: Forecasting, Schmorecasting

We’ve written about the uselessness of forecasting in the past and even cited James Montier’s wonderful piece, The Seven Sins of Fund Management.  This citation comes from Mebane Faber’s World Beta blog.  Montier writes:

The two most common biases are over-optimism and overconfidence. Overconfidence refers to a situation whereby people are surprised more often than they expect to be. Effectively people are generally much too sure about their ability to predict. This tendency is particularly pronounced amongst experts. That is to say, experts are more overconfident than lay people. This is consistent with the illusion of knowledge driving overconfidence.

Dunning and colleagues have documented that the worst performers are generally the most overconfident. They argue that such individuals suffer a double curse of being unskilled and unaware of it. Dunning et al argue that the skills needed to produce correct responses are virtually identical to those needed to self-evaluate the potential accuracy of responses. Hence the problem.

This is irony in action.  Knowledge drives overconfidence, so people who actually know something about a topic are more prone to think they can forecast, and they probably even sound more believable.  And finally, the worst performers are the most overconfident!

This may be one of the few instances in which ignorance is bliss.  If you have the Zen “beginner’s mind” and don’t make any assumptions about what might happen, you’re going to be better off than if you are knowledgeable and try to guess.

Systematic trend-following eliminates the need to forecast (although apparently not the desire, since we have clients constantly asking us what we think is going to happen).  We use relative strength to drive our trend-following; it is able to pick out the strongest trends, and those are the trends we are interested in following.  We stay with an asset as long as it remains strong.  When it weakens, we kick it out of the portfolio and replace it with something stronger.  This kind of casting-out method allows the portfolio to adapt to the market environment, as it is constantly refreshed with new, strong assets.

Despite having a logical and simple method that performs well over time and eliminates the need to forecast, soothsayers will probably always be with us—but your best bet is to ignore them.

—-this article originally appeared 3/2/2013.  Of course the lesson is timeless.

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