Personal investing

Bad predictions and good decisions

“Most of us view the world as more benign than it really is, our own attributes as more favourable than they truly are, and the goals we adopt as more achievable than they are likely to be. We tend to exaggerate our ability to forecast the future, which fosters optimistic overconfidence.” Lettie Mzwinila explains why this quote by renowned behavioural economist Daniel Kahneman matters for successful investing.

The sun will rise (somewhere)  tomorrow. The earth will spin on its axis for the foreseeable future, and time will keep going.

These things we take for granted are all predictions; some of the few that we can rely on. Nothing guarantees them, but few doubt them. This confidence in the movement of celestial objects and nature’s faithful progress encourages us to believe in the power of prediction – even when the odds prove otherwise.

Making decisions based on bad predictions

The next few months are going to be a critical period in the history of our country. The elective conference in December and its fallout will attract predictions before and after. You may have predictions about what will happen to the economy, and by false extension, to your investments.

We take shortcuts, placing too much value on our gut feeling or the casual opinions of friends.

It is instructive to remember our recent history. When the former finance minister was removed from his position in December 2015, a consensus quickly formed that the steep exchange rate drop recommended investing offshore. The currency paid no mind to this consensus and investors who fled at R16.97/US$ (on 11/01/2016) now have to make sense of an exchange rate hovering around R13/US$ (at the time of writing).

How bad predictions hurt you

We make prediction mistakes in at least two ways: by extrapolating the recent past, and by mistaking logical patterns. We may wrongly extrapolate that an investment award this year means a unit trust will continue to perform as well next year: statistically, last year’s short-term winners are more likely to be next year’s losers. We may wrongly think that strong GDP growth means higher future investment returns: statistically, GDP growth and investment returns are almost entirely uncorrelated.

We are vulnerable to these errors because we don’t have the time to get to all the facts, so we take shortcuts, placing too much value on our gut feeling or the casual opinions of friends. This even applies to an investor in something like a unit trust, where the investment decisions are made by a professional fund manager – because of the temptations of switching. Moving your investment from a recent poorly performing unit trust into a recent top performer and then back again after the previous winner does badly, is a common drag on returns.

Some rules for  better  decision-making

Using the following three steps (an algorithm, if you will) can help you consider the quality of your predictions so that you do not make rash choices.

1. Establish the facts the prediction is based on.

In a world saturated with information, it is remarkable that decisions often come from a factless basis. It is not enough to assume that market commentators or your friends have done their homework when it is your money that will be affected by the decision you make. It is equally important to resist the strong temptation to cherry-pick information that confirms your view.

2. Consider the motivations of the source.

If a prediction is made by a news source that is ideologically required to colour its coverage in positive upbeat tone or a negative bearish shade, this may compromise that prediction. More importantly, you need to consider your own psychology. Are your emotions predisposing you to think in a certain way? Merely acknowledging your own emotional state can help you take it into account.

3. Consider the opposite.

What if your prediction is wrong? Whatever decision you make should account for a range of outcomes. When professional portfolio managers construct a portfolio, they normally try to combine investments that have different risks and upsides, so that if one performs badly, the other may perform well, or will at least not be impacted.

The future is unknowable and beyond our power, but we do have the power to choose how we respond to it in the decisions we make (and the facts and implied predictions those decisions are based on).

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