Is your investment success dependent on the unfolding of a specific set of future events, such as the direction of interest rates, inflation, or the global economy? Are you relying on particular companies to outperform their competitors for as long as you own their stock? If so, you may have a problem.
Have you ever critically examined the accuracy of those who claim to be able to divine the future direction of any market? You will find that the accuracy of such predictions is about the same as if you took a random guess. How many forecasters foresaw the depth and breadth of the recent financial crisis? The Federal Reserve did not see it coming. The manager of the largest mutual fund, Bill Gross, said two months before Lehman collapsed that “there was close to 100% probability that Lehman would avoid failure.” What makes this situation even worse is that the biggest forecasting errors occur when you need the information the most—right before a major turning point.
If you stop to consider the volume and complexity of the information you would need to accurately predict the future, you begin to understand how futile the exercise is. Did anyone forecast the BP oil spill and its effect on the energy industry? Did anyone foresee the Japanese earthquake, tsunami, and nuclear power plant disaster? Did they forecast how that series of events would affect supply chains worldwide? Who foresaw the 2011 Middle East revolutions? Two years from now, who will be leading these countries? Which countries will be at war? How will this affect the price of oil? Got any idea? Would you trust a pundit who claimed to know the answer? Accurately forecasting the future is simply impossible because too many unexpected events will occur which will profoundly affect all subsequent decisions. People react to events, and others will react to the reactions. Still others will react to those reactions and the process never ends.
Let’s say you make an investment based on a prediction and the prediction does not come true. What do you do then? Your vision of the future turned out to be murky and you must recalibrate. You either suffered a sizable loss or missed a golden opportunity. After a while, you figure out how and why you went astray and make a new set of predictions. These will eventually fail as well, since you are attempting the impossible. This is not a recipe for success.
The answer is not better fundamental analysis. Wall Street analysts have a dismal track record of forecasting market direction, earnings projections, or future prices for individual securities. When academic researchers measure the results of such predictions, estimates that miss their mark by 30 – 40% are common. Such “analysis” is not helpful.
Nor is the answer found in technical analysis. Chart watchers have been brainwashed into believing the recent past can foretell the future. Once again, rigorous unbiased testing of popular technical analysis methods has demonstrated that no chart pattern has any predictive value.
Fortunately, investment success does not require the knowledge of an unknowable and unpredictable future. However, it does require a fundamentally different decision-making process from that of the crystal ball investor. This process delivers positive results in a wide range of potential future scenarios. It is based on a comprehensive understanding of the many psychological biases that affect every investor’s decision-making process. It is called Cognitive Investing.
Cognitive Investing 