Which investment experts should you believe?

  • Written by 

    Greg B Davies, Q3 2015

  • 08/07/2015

“The only function of economic forecasting is to make astrology look respectable.” Ezra Solomon1

A significant problem with investing is figuring out the ‘right’ thing to do. The investing world seems riddled with dozens of ‘experts’, often contradicting each other, but doing so with apparently sophisticated reasoning and great confidence. How do we know whose opinions of the world to believe?

Linkers versus nominals 6 of 7

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In many cases it is impossible to make this assessment based on the actual rationale the forecaster presents: these are frequently highly logical and perfectly reasonable. However, in economic forecasting, an intelligent commentator can construct a highly articulate, convincing, and well-reasoned rationale to support practically any investment thesis. So, instead of the specifics of the argument, we should look instead at the broader scope and context.

Fortunately, there are a few tell-tale signs which indicate we should not give too much weight to a particular article in deciding how to invest.

1. Is the author’s thesis betting against the house?

The strongest starting point for any forecast is that which has been observed to be the case most frequently over recorded history. The vast majority of the time economies grow, markets on average go up, and over time there is a positive risk premium from being invested. One would have to have a phenomenally clear crystal ball to warrant betting against this rather than staying the course – and if the case is that clear, why hasn’t everyone else seen it already?

If an expert has seen something with blinding clarity that no-one else has, either a) they’re far more intelligent than everyone else (see next sign); or b) they haven’t thought through alternative possibilities thoroughly (fourth sign); or c) they’re being disingenuous and selling a story (last sign).

This lack of attention to what happens most of the time is something psychologists call base rate neglect – placing too much evidence on your immediate short-term story, and too little on the underlying statistical ‘base rate’ from observed history. It is an error of reasoning, and leads to frequent investment mistakes when investors find their own current narrative so compelling that they ignore the long-term lessons of history.

This doesn’t mean that experts can’t come to a conclusion that current circumstances are sufficiently compelling to override what happens ‘most of the time’. But we should be very suspicious of any article that even fails to mention or address this point – it is evidence of muddy thinking. And recall that ‘this time it’s different’ are the four most dangerous words in investing.

This lack of attention to what happens most of the time is something psychologists call base rate neglect

2. Is the article too specific in its predictions?

For example, at the beginning of each year there is typically a slew of articles telling us with great confidence what will happen ‘in 2015’. This displays excessive overconfidence (and/or disingenuousness). Even if the reasoning of what to expect is correct to the exclusion of other viewpoints, to claim with any degree of certainty at all that this will come to pass in 2015 is overly specific. More than that, evidence would suggest that it is likely to be wrong – macroeconomic excesses and imbalances, where they exist, typically only actually get corrected well after the pundits have first called out the imbalance – as is often quoted ‘the market can stay irrational for longer than you can stay solvent.’2 Over any investment period shorter than one year there is so much uncertainty that the only honest claim is ‘we don’t know when.’

3. Is the forecast irrelevant to your investment needs?

Often pundits make calls that, even if we grant they’re right, are nonetheless fundamentally irrelevant to the needs of long-term investors. Many investment calls make zero difference to the right decision for your portfolio, so don’t waste your time and energy worrying about anxiety-inducing forecasts that shouldn’t cause you to change anything either way.

This is particularly true when the advice is to exit a well-diversified portfolio to escape some predicted short-term dip. Individual investors typically cost themselves far more by leaving too much of their cash out of the market for too long than they do by being invested through the dip and out the other side.

Further, once investors have left the market following advice such as this, even if it’s right, they usually struggle to get back in again – so even if we sit out the drop, this often doesn’t benefit us that much in the long term, and may indeed leave us worse off. We don’t have a crystal ball, but as noted above, overwhelmingly over time markets rise rather than fall, so the only sensible path for a long-term investor is to get invested, stay invested, and sit tight.

4. Is the forecast based on a single strand of reasoning?

The key problem with many predictions is not that the rationale is fallacious, it is that there are many alternative, and equally reasonable, possibilities that the author has failed to consider (or, having considered, to share). Any forecasting thesis that rests on a single strand of thought should be instantly given lower credibility; and any forecasting thesis that shows little consideration of alternative possibilities should be given lower credibility. Of course, the author may have done this thinking and just not be showing it, but we have no way of knowing that, and it discredits the forecast. Forecasting articles are generally written to provide a convincing narrative, rather than a thoughtful analysis. As a general rule of thumb: the more confidence with which someone tells you they know what is going to happen in the markets, the less you should believe it.

To know who to believe we should give greater weight for those who show evidence of using a devil’s advocate to challenge their own thinking – making sure they’ve put to themselves the arguments their opponents would.

Pundits are frequently driven by the desire to enhance their public image as a pundit

5. Does the pundit have an ulterior motive?

As much as investment experts might like to think they’re being entirely objective, most are motivated in part, consciously or not, by other things: in particular, pundits are frequently driven by the desire to enhance their public image as a pundit. Sadly clear, confident, provocative opinions that gloss over the fundamental uncertainty and complexity of the real world sell much better than carefully circumspect thoughts on how little we really know about the messy underlying reality.

In some cases, of course, the motivations are even more self-interested – for example, a bond fund manager presenting a single stranded (though quite logical and reasonable) rationale for why we should all, well, erm, buy bonds. This, of course, doesn’t mean that such pundits are being intentionally disingenuous and just crafting a sales pitch (though this possibility should give us pause for thought). They could simply be very bound up in their own world view and so naturally see evidence for what they are preconditioned to believe in.

Psychologists refer to this as confirmation bias: we naturally seek corroborating evidence for our existing beliefs; we give lower credence to evidence that is contrary to our existing beliefs; and we interpret neutral evidence as being supportive for our existing beliefs. (This has all been well demonstrated experimentally, but closer to home it’s a rare person who can genuinely say they don’t spend much more time reading the newspapers and thinkers they already agree with, rather than those they don’t.)

Sad as it is to admit it, although we like to think our beliefs follow from the logical arguments we construct based on evidence, a great deal of the time it is the other way around: we construct logical arguments to justify what we already believe. These arguments can be astonishingly articulate and sophisticated, but inevitably involve cherry picking the evidence we like, and suppressing that which we don’t.

Ultimately, all investment ideas are going to be filtered through the prior beliefs of those advocating them, and so all are going to reflect a biased view of the world in one way or another. However, to invest with confidence we do need to enhance our own understanding of the world, and the views of expert commentators can help with this. The solution is not to ignore investment pundits, but rather to read them critically: the more of the above questions that can be answered ‘yes’ for any investment article, the less value that article has for your investment decisions, and the sooner you should stop reading and move to something that is a better use of your time.

Avoid investment forecasts and ‘experts’ that have a lot of the features on the left-hand side of the table; seek investment pundits whose writings have the characteristics on the right-hand side.

TABLE: Incline to Scepticism

1 Frequently attributed to J K Galbraith. The more famous the writer, the more believable the quote. The same is true of investment ideas – beware of ascribing more credibility to an investment idea than it deserves just because it is espoused by a famous name.
2 As with the Galbraith quote, this quote is frequently attributed to Keynes, thereby acquiring a patina of credibility…however the first recorded instance isn’t until 1993 (he died in 1946).