Bullish On Books

Most of us don’t care much for mysteries. We’re not comfortable with letting life just happen. We want to know what will happen, when.

We want to know everything from what time the sun will rise to finding the perfect time to sell or buy stocks.

And for those who really hate not knowing – many found comfort in the writings of Nostradamus whose predictions included when the world will come to an end.

Lot’s of people find comfort in believing we can predict and thereby control our future. But in the new book, DANCE WITH CHANCE: Making Luck Work For You the authors show while that belief may be psychologically comforting, there are dangerous consequences to underestimating the role and power of chance.

This guest blog was written by Robin Hogarth DA co-author of “DANCE WITH CHANCE"

Dance with Chance

Across history, humans have prospered by learning to predict. Today, we forecast many important physical phenomena with stunning accuracy: sunrise and sunset, times and heights of tides, even – on a good day – the weather.

At the same time, we humans are reluctant to recognize that we cannot predict many important economic and social phenomena with any reasonable degree of accuracy. In business and finance, for instance, there is ample evidence that the forecasting errors of statistical models – and particularly complex ones – are quite large. In fact, it’s almost an empirical rule that the more mathematically sophisticated the model, the less accurate its forecasts.

Take the IMF, for example. It’s home to some of the world’s greatest brains, largest data banks, and latest statistical techniques. But in April 2008, four months after the recession had started in the USA, the IMF’s forecast was for global growth “to slow to 3.7 percent in 2008 (…) and to remain broadly unchanged in 2009.” In other words, it predicted “slowdown” instead of “meltdown.”

Given this predicament, it’s tempting to dispose of all models and rely on intuition. But alas, across a wide range of practical domains, intuition has an even worse predictive track record than statistical models.

Perhaps the biggest problem is that our imaginations tend to be dominated by the immediate past.

For example, at the end of the 1980s there was a flurry of books predicting depressions, while at the end of the 1990s the mood changed to euphoria. Huge changes in forecasts are not uncommon. In March 2008, for instance, Goldman Sachs

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[GS  Loading...      ()   ] predicted the price of a barrel of oil would reach $200 in the non-too-distant future, but then it lowered its forecast to $80 and again to $45, in December 2008, as actual oil prices kept falling.

It’s time to accept that neither models nor humans possess crystal balls. We advocate, first, establishing just what we can and cannot predict and, second, developing strategies to handle cases where forecasting is futile.

Clearly, we are unable to predict when the current crisis will end or when the Dow will reach bottom. However, we do know that the US stock market has been growing, in real terms, about 7% a year on average for over two hundred years. What we cannot predict are the huge short- and medium-term fluctuations around this average. The same is true for economic growth, real commodity prices and real wages, which are all highly stable in the long run, but also exhibit strong, unpredictable, short- and medium-term variations.

When this article was written, the Dow had dropped 53.8% from its 2007 peak and everyone was talking about a catastrophic decline. But not long ago, between 10 March 2000 and 9 October 2002, the NASDAQ fell 78%. Similarly, on 30 April 2003 the Nikkei had dropped 80% from its peak. These movements characterize stock market behavior. And yet, because people have short memories, they are frequently ignored. Collective amnesia seems to erase bad experiences – and the associated inaccurate forecasts.

Forecasting often just provides illusions of certainty. However, once we accept this, we’re free to take actions to cope with the ensuing uncertainty. Here are some of many strategies we already use:

Insurance: Since we cannot predict when an automobile accident will occur, we use insurance to protect ourselves. It’s possible to achieve the same effect in business and finance using a wide variety of insurance-type instruments.

Reserves: Since firms cannot predict which debts will go unpaid, they build reserves against bad surprises. Similarly, companies can establish “recession reserves” from the excess earnings of boom times.

The venture capitalist approach: Venture capitalists accept they can’t predict exactly which start-ups will take off. They therefore invest in several ventures so that the successes can cover the costs of the failures. Again this is an approach that other types of business can adopt. Indeed, some book publishers have been doing it for years.

Simply being prepared: It’s impossible to predict large earthquakes and hurricanes. In areas susceptible to such natural disasters, the smart strategy is to build structures capable of withstanding their effects – if affordable. The aim is to avoid or minimize damage by being prepared. The same strategy applies to escape plans for buildings. You need a plan, even though you don’t what will trigger an emergency, e.g., fire, terrorist attack, etc.

The current economic crisis is ample evidence that we cannot make accurate socio-economic predictions. However, our inability is not confined to business and economics. It extends to forecasting our own longevity, success and happiness.

Now, we don’t advocate abandoning attempts to predict. There are two reasons:

The first is that to predict is human. We just “need” to see the future. But second, if we keep records of predictions and outcomes, we can learn from our errors – and stretch our imaginations to see more possible futures.

In short, forecasts are inevitable and can be useful provided we understand their limitations. In particular, knowing when prediction is futile, effort and resources can be better spent on contingency planning for surprises rather than trusting in inherently illusory guesses.

There is some utility in the inherent futility of forecasts. 

__________________________

Robin Hogarth

Robin M Hogarth (formerly of the University of Chicago) is now ICREA Research Professor at Universitat Pompeu Fabra, Barcelona and President of the European Association for Decision Making and coauthor of the new book DANCE WITH CHANCE: Making Luck Work For You (Oneworld Publications).

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