Don't predict ... sell future insurance

If you take a monthly look at annualized Dow Jones returns from 1930 to 1950, you find 28 percent of the periods produced an annual loss of greater than 10 percent. Monte Carlo simulations made in 1950 would have reflected this, resulting in a rather dismal forecast for the 1950s. But in reality only 2 percent of 1950s’ annualized returns had losses greater than 10 percent. Indeed, 48 percent of the periods produced double digit gains in the ’50s. However, if your portfolio allocation was based on this predictive tool, your performance would have suffered.

If you take a monthly look at annualized Dow Jones returns from 1980 to 2000, you find 59 percent of the periods produced an annual gain of greater than 10 percent. Asset allocation models using Monte Carlo simulations in 2000 reflected this optimism going forward into the 21st century (Dow 30,000, anyone?). However, we now know that optimism was misplaced.

Wall Street often persuades clients to give them money by indirectly hinting they can predict the future, but they can’t, because humans don’t know what will happen tomorrow. The past is used as a predictive tool because it is easier to show a number rather than describe a concept and, frankly, we are all searching for the person who can predict the future, even though we realize the futility of doing so. However, there is a way to stand apart from the crowd of false soothsayers.