I like explaining things through headlines. A few summarizing words is often all you need to tell a long story.
For example, you can sum up the madness of investor psychology with these two headlines of expert forecasts, both heavily plugged during their respective times:
October, 1999: "Analysts Say Dow Will Rise Up to 36,000"
June, 2010: "[Analyst] Says Dow Could Fall to 1,000"
Mind the gap
Staggering. In 11 years flat, the most hyped-up and oft-cited market forecast collapsed by 36-fold. Yet what changed during those 11 years? In 1999, GDP was $9.3 trillion; today, it's well more than $14 trillion. In 1999, the S&P 500 earned $51.68 per share; this year, it's on track to earn $82.
Rationally, none of this makes any sense, until you remember what else changed in the past 11 years: Average investors were drunk with optimism in 1999, and they are equally smashed with fear today. Bullheaded expert forecasts like the two above help explain why.
That isn't a profound insight, I'm aware. But the way expert opinions influence investor psychology suddenly has a new meaning to me.
I just finished the book Expert Political Judgment, by U.C. Berkeley professor Philip Tetlock. This isn't a new book -- it was published four years ago -- but its findings are probably more relevant today than they've ever been.
Twenty-five years ago, Tetlock began compiling a database of expert forecasts, hoping to find out who was capable of making good predictions, and why. Here's what he found:
1. As a group, expert forecasters are horrendously bad at what they do, rarely beating the predictions of a "dart-throwing chimp."
2. Experts can get away with lousy predictions, because the media doesn't offer an objective scorecard on past calls. "If it were easy to set standards for judging judgment that would be honored across the opinion spectrum and not glibly dismissed as another sneaky effort to seize the high ground for a favorite cause, someone would have patented the process long ago," writes Tetlock. People still ogle when Abby Joseph Cohen makes a bullish call, permabull status and past performance be damned. Why? Because she works for Goldman Sachs
3. There's very little correlation between experience and accuracy. Someone who's been in the business for 50 years isn't statistically much better than a rookie. "As expertise rises, confidence in forecasts should rise faster than the accuracy of the forecast, producing substantial overconfidence," Tetlock notes.
4. There's a negative correlation between experts' popularity (measured by media appearances), and accuracy. The more popular they are, the less accurate their predictions become. Chalk that up to hubris. "The more frequently experts are asked to offer their opinions on current events to the media, business, or government," Tetlock explains, "the greater the temptation to offer quotable quotes and good sound bites."
5. People who trumpet one extremely bold, all-encompassing theory and stay glued to their foundation are painfully inaccurate. Tetlock calls them hedgehogs. Those who make many small predictions and constantly update their outlook based on new information have a pretty good track record. He calls them foxes.
That last one is the most important. In a 2009 interview, Tetlock explained how investors can differentiate between hedgehogs and foxes:
Count how often they press the brakes on trains of thought. Foxes often qualify their arguments with "however" and "perhaps," while hedgehogs build up momentum with "moreover" and "all the more so." Foxes are not as entertaining as hedgehogs. But enduring a little tedium is worth it if you want realistic odds on possible futures.
This makes a lot of sense. Those who stay flexible and realize the world is dynamic are better judges than those who pretend it's built on certainties.
What's sad is that today's world is knee-deep in hedgehogs, and we pay scarce attention to the foxes. There are foxes out there right now making predictions that have a high probability of coming true -- the blog Calculated Risk comes to mind. Unfortunately, the media buries their voices in obscurity. They speak too softly. They're too dull. Too logical. Instead, we get Jim Cramer on live TV five days a week, with an occasional smattering of Lenny Dykstra bonus calls.
You know the other obvious hedgehogs: Those who dismiss anything less than gold at $5,000 an ounce as drivel; those who claim Sirius XM
Pardon the maniacs
As for Dow 1,000? Most of us have forgotten that Robert Prechter was calling for Dow 777 (no zeros emitted) in 2002 as well. Once again, we've done a poor job keeping score.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.