Forecasters not unlike dart-throwing chimpanzees

SERIOUS MONEYTHE HOLIDAY season is over and buy-side investors are busy returning to work to find in-boxes filled with brokerage houses' lengthy prognostications for the year ahead.

The latest round of crystal-ball gazing, which follows a volatile but flat year for the major US stock market averages has seen the market seers simply push forward the initial index targets they made at the start of 2010 to the end of the current calendar year. Once again, the Wall Street experts call for double-digit price gains in the year ahead.

The sell-side strategists never seem to tire of issuing forecasts that prove subsequently to be embarrassingly wide of the mark, and continue to pencil in annual stock market gains of 10 per cent or more, year-in year-out.

Stock market performance has continued to frustrate such lofty expectations for a decade and more.

Had the seers’ annual predictions borne fruit each and every year since the SP 500 first reached current levels way back in the early days of 1999, the index would now exceed 4,300 – or roughly 3,000 points higher than last year’s close.

The evidence suggests American economist Alfred Cowles was indeed correct to conclude his 1933 article, Can Stock Market Forecasters Forecast?, with the words “It is doubtful”.

The investment strategists may have performed miserably. But their economist friends have hardly done any better, having failed to anticipate each and every downturn in the US economy over more than three decades.

Indeed, in March 2001, for every dismal scientist signalling for recession, there were 19 others expecting the business expansion to continue – even though an economic contraction was set to begin within days.

Similarly, a survey of 54 economists by Business Weekin December 2007 reported that not one expected even a mild business downturn in the near future – just as economic activity was set to plummet at the most rapid pace since the 1930s.

In this light, it’s hardly surprising that late educator Laurence J Peter once quipped “an economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today”.

In fairness, an inability to make accurate predictions is not confined solely to investment professionals and economists.

For example, researchers from the American Child Health Association, concerned about the high rate of child tonsillectomy and consequent children’s welfare, conducted a landmark study in 1934 that cast considerable doubt on paediatricians’ diagnostic skills.

The association surveyed 1,000 11-year-olds from New York city’s public schools, of which 611 had already had their tonsils removed. The remaining 389 children were sent to a group of school doctors for examination. These determined that 174 students required tonsillectomies.

The 215 children who had been instructed that that they did not need their tonsils removed were then examined by a further panel of doctors, and surgery was recommended for a further 99 students.

This process of obtaining additional opinions for children who had previously been told they did not need their tonsils removed continued for another round and, of the 116 children remaining, an additional 51 were selected for tonsillectomy.

After just three examinations, just 65 of the original 389 “healthy” children were not being recommended for tonsillectomy and, upon each investigation, the doctors determined that roughly 45 per cent of the remaining children required surgery.

This disturbing result doesn’t say much about the surveyed doctors’ diagnostic skills but the persistent rate of prescribed tonsillectomy is eerily similar to the double-digit annual returns anticipated by sell-side strategists year after year.

Perhaps the most comprehensive research on the accuracy of expert judgment was carried out by Philip Tetlock, a professor of psychology, business, and political science, who published his findings in the 2005 bestseller, Expert Political Judgment: How Good Is It?

Tetlock’s authoritative study spanned more than a decade and encompassed 284 experts “giving 27,450 judgments of the future”.

He concluded that the experts would have been beaten by “a dart-throwing chimpanzee”.

The bottom line is that professionals in all walks of life – and not just the investment world – have an inflated view of their abilities.

Of course, this is to be expected: after all, should an individual actually think otherwise, one could reasonably ask such a person why they would even consider continuing to practise in their chosen field of expertise.

However, high levels of overconfidence have been shown to be dangerous, where “the more famous the expert, the worse he did”.

So-called experts typically suffer from the illusion of knowledge – the more facts that an expert has available to them, the more information they have to enlist to support their opinions.

Further, experts usually place too much emphasis on information that supports their opinions and downplay the facts that support an altogether different conclusion.

As the political scientist Harold Laski observed in 1930, “Expertise . . . breeds an inability to accept new views.”

The case against expert opinion is overwhelming but, as Scott Armstrong, an expert on forecasting notes:

“No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers.”

Investors would do well to remember that sell-side predictions can damage your financial health.

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