The Little Book of Behavioral Investing: How not to be your own worst enemy

Chapter Five

The Folly of Forecasting

Prepare—Don’t Predict

 

 

 

 

 

 

AS THE SIXTH-CENTURY BC POET and philosopher Lao Tzu observed, “Those who have knowledge don’t predict. Those who predict don’t have knowledge.” Yet, most of the investment industry seems to be obsessed with trying to guess the future. This stems from the way many investors are taught to think about investing. For instance, when we learn about the favorite valuation metric of finance—discounted cash flow—we are taught that we have to forecast cash flows for the firm way into the future, and then discount them back to the present.

However, as Charlie Munger has pointed out, “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they ’ve got to do something.”

This whole enterprise of trying to be a financial soothsayer seems largely doomed to failure because of the behavior pitfall from the previous chapter—overconfidence.

Let’s say you invest according to the following process: Forecast the economy, forecast the path of interest rates, forecast the sectors which will do well within that environment, and finally forecast which stocks will do well within that sector.

Now let’s assume you are pretty good at this and you are right on each forecast 70 percent of the time, which is massively above the actual rates of accuracy ...