“He who sees the past as surprise-free is bound to have a future full of surprises,” wrote the late cognitive psychologist Amos Tversky.
Tversky did ground-breaking research with Nobel-prize winner Daniel Kahneman into the cognitive errors that bedevil decision-makers, especially investors. Tversky argued that our tendency to construct neat, after-the-fact narratives of why something happened obscures just how random and unpredictable the world really is.
Our habit of constructing false order out of random events in the past sets us up for disappointment: It makes us think we should be able to predict the future. When we cannot do so, we attribute our failure to lack of skill or intelligence, rather than acknowledging how uncertain things are, says author Michael Lewis in his new book, “The Undoing Project: A Friendship That Changed Our Minds,” (New York: W.W. Norton & Co., 2017), which recounts the long partnership of Kahneman and Tversky.
Tversky made a memorable presentation in 1972 to a group of historians at the University at Buffalo in which he told them that even though we find it hard to predict an event in the future, once it has happened we explain why it happened “with a great deal of confidence.”
“This ‘ability’ to explain that which we cannot predict, even in the absence of any additional information, represents an important, though subtle, flaw in our reasoning,” Tversky said. “It leads us to believe that there is a less uncertain world than there actually is, and that we are less bright than we actually might be. For if we can explain tomorrow what we cannot predict today… then this outcome must have been determined in advance and we should have been able to predict it.”
In the real world, however, events are not pre-determined. Anything can, and often does, happen. Investors who just suffered through a highly unpredictable election season and ensuing stock market rally should acknowledge this, assuming they are honest with themselves about what they “knew” last year and what they know now.
One of Kahneman’s students, Baruch Fischhoff, dubbed the phenomenon described in Tversky’s talk as “hindsight bias.” This is exactly the bias that fills the news stories that appear daily after the stock market closes, stories that make it obvious that a good productivity report that day caused the market to rise, or a slowdown in the Chinese economy scared investors and caused them to sell. The implication is that an astute analyst should have seen it coming and been able to predict at the market’s 9:30 a.m. opening what would happen that day.
Investors should stop searching for the market guru who will predict the future for them and improve their investment returns. Quite simply, no one can. Many of those who want to sell investment products to you will tout their own abilities to do so and often will selectively present as “evidence” lucky predictions they made in the past. If you make enough predictions about the future, however, you are bound to be right occasionally simply by the laws of chance. But you are also likely to be wrong enough times that it’s not worth betting your financial future on that next prediction.
The best strategy is to ignore your own or anyone else’s predictions and to construct an all-weather, diversified portfolio that will participate in market gains but also shelter you from the worst effects of market declines.
Richard Schroeder, CFP®, Chief Investment Officer