Americans have a prediction problem. We love to predict things, but sadly, we're not very good at it.
This is the central argument in Nate Silver's new book, The Signal and the Noise. Silver, who has become America's leading expert on political polling, describes the signal as "the truth" and the noise as that which "distracts us from the truth." Ultimately, he believes we can all improve in our attempts at accurately forecasting the future.
Silver's book is particularly relevant to investors, who are always making predictions about stock prices and overall market movements. I recently read Silver's 544-page book, and came away with five clear lessons for investors.
1. Economists aren't very good at forecasting.
Prior to the financial crisis, I can remember talking to a lot of investors who didn't pay too much attention to macroeconomic factors. After the crisis, it seemed like everyone, including the intern who got a C+ in Macro 101, had an opinion on interest rates, inflation, and currency trends.
Silver shows in his book that economic forecasts are often quite poor, and that economists are much too confident in "their ability to predict the direction of the economy." I found one particular statistic quite shocking: "in the 1990s, economists predicted only 2 of the 60 recessions around the world a year ahead of time." Overall, Silver argues that the gap between how forecasts actually do and how people think they will do is considerable. So, regardless of whether someone has a Ph.D. from MIT or a GED from Online High, be skeptical of big macro forecasts and how'll they affect the stocks you like.
2. Investors should think probabilistically.
Perhaps one of the biggest takeaways from Silver's book is that anyone making a forecast should think "probabilistically" -- in other words, they should try to determine the odds of a particular event happening. And Silver believes that all of us must embrace uncertainty in order to become better at making forecasts.
This is particularly good advice for investors. Let's face it, no one truly knows for certain what will happen in the future to any given stock or even the market in general. Would anyone in, say, 2006, have been able to foresee that Bank of America (NYSE:BAC), AIG (NYSE:AIG), and even Goldman Sachs (NYSE:GS), in addition to several others, would be on the verge of collapse just two years later?
Of course they wouldn't. That's why Silver encourages investors to never think in terms of "no-lose bets, unimpeachable theories and infinitely precise measurements." Instead, investors should do their best to determine the odds of whether or not a stock might outperform. And then size the position accordingly.
3. Ordinary investors are overconfident when making predictions.
Silver tells us that the "central finding of behavioral economics is that most of us are overconfident when we make predictions." And he provides evidence that investors are particularly big offenders in this area.
After reading Silver, a big lesson for me is that most investors would probably improve their performance if they were more humble and accepting of the possibility of being wrong. As an example, my colleague David Meier and I bought shares of Facebook (NASDAQ:FB) back in May. We had high hopes for the stock, while also having concerns about the valuation. The stock is now down approximately 40% since that purchase. Fortunately, we knew at the time that we might be far too early, so we only bought a small position. By recognizing that we might be wrong, we avoided a much bigger loss.
4. It's not easy to beat the market, but some people do.
Silver thinks that the Efficient Market Hypothesis is probably more robust than many individuals think. But he also thinks that some institutional and retail investors can outperform the market, and believes that sometimes the price of an asset is wrong.
After looking at various studies, Silver feels there is strong empirical evidence for Yale economist Robert Shiller's theory that investors should buy during times of low market P/Es, and sell during times of high P/Es. He notes, however, that investors would need to be extremely patient in order to profit from that particular strategy.
5. It's important to test your ideas.
Coming up with probabilities for the likelihood of future events is hard. And it may be a foreign way of thinking for many of us. To make matters worse, we often remember our accurate predictions, while conveniently forgetting (or ignoring) our inaccurate ones.
That's why Silver encourages us to test our ideas. Testing allows us to practice and learn from our mistakes. In the investing realm, watchlists and virtual stock-picking platforms like Motley Fool CAPS are great ways to test your prediction skills. Be sure to devote time to looking back at some of your failed predictions, too. Remember, even the best investors are right only six times out of 10.
It doesn't need to be this way
Nate Silver has written an outstanding book that I can't recommend enough. In addition to investing, he covers a wide array of topics, from baseball to poker to climate science. Through it all, we learn that we're really not all that good at predicting things. And yet, all is not hopeless. We can get better at this, and Silver's book is an excellent place to start.
John Reeves has no positions in the stocks mentioned above. The Motley Fool owns shares of American International Group, Bank of America, and Facebook and has the following options: long JAN 2014 $25.00 calls on American International Group and long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend American International Group, Facebook, and Goldman Sachs Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.