From the January 2015 issue of Research Magazine • Subscribe!

Finance's Trek Into Forecasting Chaos

Photo: © Steve Schapiro/Corbis Photo: © Steve Schapiro/Corbis

In the Star Trek universe, the Kobayashi Maru is a Starfleet Academy training exercise for future officers in the command track. It takes place on a replica of a starship bridge with the test-taker as captain. In the exercise, the cadet and crew receive a distress signal advising that the freighter Kobayashi Maru has stranded in the Klingon Neutral Zone and is rapidly losing power, hull integrity and life support.

The cadet is seemingly faced with a decision: (a) to attempt to rescue the freighter's crew and passengers, which involves violating the Neutral Zone and potentially provoking the Klingons into an all-out war; or (b) to abandon the ship, potentially preventing war but leaving the freighter's crew and passengers to die. As the simulation is played out, both possibilities are set up to end badly. Either both the starship and the freighter are destroyed by the Klingons or the starship is forced to wait and watch as everyone on the Kobayashi Maru dies an agonizing death.

The objective of the test is not for the cadet to outsmart or outfight the Klingons but rather to examine the cadet's reaction to a no-win situation. It is ultimately designed as a test of discipline and character under stress.

However, before his third attempt at the test while a student, James T. Kirk surreptitiously reprograms the simulator so that it is possible to rescue the freighter. When questioned later about his ploy, Kirk asserts that he doesn't believe in no-win scenarios. And he doesn't like to lose. So he changed the game. Thus for Trekkies, the test's name is used to describe a no-win scenario as well as a solution that requires that one change the game in order to jerry-rig a solution to the proffered problem.

For would-be market experts, their Kobayashi Maru is a public market target, most often included in an annual market preview publication. It's an expected part of the gig. Similarly, when a Wall Street strategist, economist or even run-of-the-mill investment manager or analyst gets a crack at financial television, he or she is routinely asked, often as almost an afterthought, to give a specific target forecast for the market. Instead of thinking like Captain Kirk and wisely objecting to the premise of the question, the poor schlemiel answers and, once matters play out, is shown to have been less than prescient. Indeed, as I often say, one forecast that is almost certain to be correct is that market forecasts are almost certain to be wrong.

Every December I take a look at these predictions for the year that's ending and they are almost always uniformly lousy. Moreover, when somebody does get one right or almost right, that performance quality is not repeated in subsequent years. That's because, at best, complex systems—from the weather to the markets—allow only for probabilistic forecasts with very significant margins for error and often seemingly outlandish and hugely divergent potential outcomes. Chaos theory establishes as much. Traditional market analysis has generally failed to grasp the inherent complexity and dynamic nature of the financial markets, while chaotic reality goes a long way towards explaining highly remarkable and volatile outcomes that seem inevitable in retrospect but were predicted by almost nobody.

The 2014 expert predictions held true to form. I performed a survey of published 2014 year-end target forecasts for the S&P 500 from 50 very prominent investment strategists and money managers. It tracked their “achievements,” using forecasts from the beginning of 2014. Results:

Median forecast for year-end 2014: 1,950 (up 6.44 %).

S&P 500 actual (through November 2014): 2067.56 (up 11.86 %).

The bottom line is that other than a very few notable exceptions (luck abounds), all the alleged experts missed and missed by a lot (short of a major market move between this writing and the end of the year). Indeed, the S&P 500 (through the end of November) returned 84% more than the median expert prediction. Astonishingly, that's a lot better than last year though still dreadful.

To be fair, these horrible results aren't at all unusual. Market forecasting has a long and disreputable history, as I have noted in this space before. Irving Fisher was a highly regarded 20th century economist. No less an authority than Milton Friedman called him “the greatest economist the United States has ever produced.” But three days before the famous 1929 Wall Street crash he claimed that “stocks have reached what looks like a permanently high plateau.” That's just one ignominious and high profile example among many.

Let's stipulate that these alleged experts are highly educated, vastly experienced, and examine the vagaries of the markets pretty much all day, every day. Even so, it remains a virtual certainty that they will be wrong and often spectacularly wrong. If you think you can predict the future in the markets, think again. Your crystal ball does not work any better than anyone else's.

It's easy to poke fun at these forecasts, of course. But the sad truth is that we are forced to make forecasts all the time. Humans are unique in our ability to imagine different futures. Our brains are forecasting machines. We leave for work based upon how long we expect it will take to get there. We plan our Saturdays based upon how good we think that day's college football schedule is. We create retirement savings plans, portfolios and retirement income plans based upon our forecasts of future events and expected returns. There is no way around it, which makes investing successfully really hard.

Therefore I offer a few suggestions—a Top 10 list of New Year's resolutions, perhaps—for how to deal more effectively with the forecasts we must make in an environment that largely precludes us from making good ones over the longer term.

  1. Be more modest about one's forecasts and abilities generally.

  2. Allow for much larger margins of error.

  3. Beware apparent certainty, apparent precision and excessive complexity.

  4. Lower costs and saving more matter a lot.

  5. Prepare for wildly different potential outcomes (because luck has a huge impact on even the best plans), focusing on process and what can actually be controlled.

  6. Look to avoid big risks and big mistakes as doing so matters much more than our successes.

  7. Diversify, diversify, and diversify some more.

  8. Correlation is not causation, consensus is not truth and what is conventional is rarely wisdom.

  9. Set careful goals (with contingencies), review and adjust them regularly and be accountable for what happens.

  10. When you’ve won the game, stop playing.

As my friend Cullen Roche points out, the smartest investors know that they’re not really all that smart. They recognize that they’re going to be wrong and wrong a lot. Their forecasts won't be very good very often. But they also recognize that they don't have to be right all the time or even nearly all the time to reach their goals. They simply have to avoid big mistakes and be right about the important stuff when it matters.

For too many of us too often, investing is a Kobayashi Maru. The way the financial media and most “experts” would have us play the game, we have no chance to succeed. If we’re going to win, we need to change the game.

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