Why do 100% of economists say that it’s hard to predict stock prices?

Answer by Laurent Bernut:

“Forecasting is a difficult business, particularly when it is about the future”, Yogi Berra, modern American philosopher

Economists are extraordinarily helpful at predicting … the past. They will give today a savant explanation as to why their predictions for last week did not pan out. Economists gather some attention during bear markets when all predictions turned out be wrong anyways and investors want to gauge the “real economy”. Now, not only economists are wrong. Analysts are appalling and strategists are laughable. We, as a species, are biologically incapable of forecasting anything.

Experts cannot predict

In early 2008, before the GFC, my friend Marco Dion, quants guru at JP Morgan, wrote a piece about analysts earnings forecast accuracy 1 year out.

The probability of being spot on is a whooping 2%. The correct terminology for such low percentage is statistical error: “oops, I got it right”…

The probability of being +/-10% was 25%. That is half a coin-toss.

I used to compile strategists’ predictions published in Barrons and measure forecast accuracy twice a year. Fasten your seatbelt. If You thought analysts were bad, You haven’t seen anything yet. Forecast accuracy of Barrons roundtable was 17%. That is simply a few notches below useless, that is laughable.

(The primary reason why strategists were so low is primarily the broad range of questions from interest rates to currency, S&P levels. Within their domain of competence (fixed income, equities or currencies), they were relatively OK  but were tragic everywhere else)

Why we can’t predict 

Our “ability to predict” is located in the prefrontal cortex. It is the siege of our thinking brain. Now, within that brain, there are several regions invoked every time we make a prediction.

“High conviction” predictions trigger a zone called the ventro-median prefrontal cortex. The interesting part is the dorsolateral cortex, where our ego and identity gets activated. Hal Hershfield has observed through fMRI dual activation in those regions when subjects asked to make projections about their financial well being claimed to have good financial literacy. In other words, people who claimed they knew something about the subject were also more prone to overconfidence. Our forecasts are contextual.

A third thing that makes it even more interesting is something called recency bias. We extrapolate tomorrow based on what we know today. Have You ever wondered why analysts earnings prediction go in straight line up through the next 20 years ? It does not even dawn upon them there could be a dip.

Maybe we asked the wrong question in the first place

Back in the 60s, there were a series of studies conducted at Yale University where subjects were asked to send electric shocks to test subjects if they answered wrong (Milgram experiment ). Of course, test subjects were actors and no shocks were sent, but the interesting part was that few people rebelled. The objective was to measure compliance to authority, specifically how could people obey nazi orders and send victims to a certain death. We are conditioned to respect figures of authority and experts.

Yet, in finance, we still avidly seek the opinions of experts who continue to prove time and again that they are hopeless at it: they are still several standard deviations below a coin-toss. So, why do we still rely on them ?

Rather than running an ugly contest on who’s worse at forecasting, maybe we should ask ourselves a better question: despite overwhelming evidence that we are hopeless at forecasting, why do we keep doing it ?

Our fear receptor is a region in our brain called the amygdala. These are two glands in the center or our brain. They are our fear receptors. The amygdala has helped our ancestors survive saber tooth tigers. It has not evolved for thousands of years. In the Jungian and later Pearson Marr archetypes, amygdala could be compared to the orphan.

Now, our primitive brain does not know the difference between a saber tooth in the bush and a news headline. Uncertainty triggers fear. This fear activates the amygdala.

So, we rely on “experts” who know better and can reassure us and soothe our uncertainty. In other words, we delegate our fear management to experts.

Is there a better way then ?

Uncertainty is not going away anytime soon. Uncertainty and risk are part of life. Rather than delegating fear management, maybe we should learn to live with it, to make peace with it. Fear exists in the shadow and evaporates when brought to light.

1. Mindful meditation: There are several techniques designed to reduce fear, one of the best being “mindfulness meditation”. I would also recommend the work of my trading coach Rande Howell (trader’s state of mind).
2. Risk is a number: The second way is to quantify risk and stop loss. Risk is not a paragraph at the end of a dissertation called investment thesis. Risk is a number: know how much you are willing to risk and can afford to lose before entering any trade.

Conclusion

“Forecasting is a difficult business, particularly when it is about the future”, Yogi Berra, modern American philosopher

We are hopeless at forecasting. Forecasts have been wrong and no matter how technology evolves, they are likely to be wrong in the future as well. (I had this conversation with Nate Silver in Hong Kong actually). Even if forecasts accuracy doubled, it would still be below a coin toss. So rather than trying to improve them, how about learning to live without them ? How about growing comfortable without discomfort ?

If You are interested in how “Greed and Fear” tricks our brain: Amygdala and the neurophysiology of Greed and Fear. and, don’t forget to sign-up if You want to receive free bonus material

Why do 100% of economists say that it’s hard to predict stock prices?