One story related by Peter L. Bernstein in “Against the Gods: the remarkable story of risk” was the experience of Kenneth Joseph Arrow, an American economist and joint winner of the 1972 Nobel Memorial Prize in Economics.
Some officers had been assigned the task of forecasting weather a month ahead, but Arrow and his statisticians found that their long-range forecasts were no better than numbers pulled out of a hat. The forecasters agreed and asked their superiors to be relieved of this duty. The reply was: “The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.”1
Philip Tetlock, a psychologist at the University of California, Berkeley, has literally spent a lifetime looking at how well experts in their field do with respect to their professions. Over a period of 20 years he collected the predictions of 284 people who made their living “commenting or offering advice on political and economic trends,” including journalists, foreign policy specialists, economists and intelligence analysts. By the end of the study, Mr. Tetlock had quantified 82,361 predictions. How did the experts do? The vast majority of the predictions were worse than random chance. Post graduate degrees offered no advantage. Famous experts tended to do the worst.
Where did these individuals go wrong? According to Mr. Tetlock the main reason was overconfidence. Convinced that they were right, the experts ignored evidence suggesting they might be wrong. Another important bias is that most experts find it very difficult to make a negative prediction. Fear of “crying wolf” may be part of the reason, but there is also a desire to please the audience and be re-elected, or asked to speak again. Another important cognitive bias, Mr. Tetlock points out, is that most of us find it very difficult to change our minds.
Overconfidence and “confirmation bias,” where experts ignore evidence suggesting they are wrong, are of particular concern to investment advisers. With the financial security of our clients at risk, we can’t afford to become “prisoners of our preconceptions,” as Mr. Tetlock puts it. This is one reason why active management relies heavily on non-emotional, technical and quantitative analysis and mathematical relationships within the financial markets. Our goal is objectivity and discipline, checking our ego and emotions at the door. The most important information for an active manager is not where the market has been or where we believe it is going, but where it is today.
By setting very specific investment rules as to when an asset will be purchased or sold, or when it is safe to be invested in equities or bonds or a specific sector, or when a defensive posture is better, our goal is to avoid letting our biases and emotions influence our decisions. I may be right in my belief that the market will recover from its current malaise, but to base a client’s portfolio on that belief ignores the consequences of being wrong. What if I am right on the market’s direction but completely wrong on the duration of the problem?
Active management is risk management. As with all tools to limit risk, it can also result in lost opportunities if conditions change quickly. But without risk management, without basing investment decisions on where the market is today, the risk of a major drawdown impacting the client’s future increases.
1 Against the Gods, Peter J. Bernstein, page 203.