Financial Forecasts: How to Separate Guesswork From Homework

May 14, 2012— -- The Dow Jones industrial average shot up 30 percent between January and April, but has since given back half of these gains. Investors are naturally wondering: Will stocks resume their upward climb? Or is another treacherous bear market waiting around the corner?

These are questions that investors obsess over. The only correct answer is simply that no one knows. Though most investors realize we live in a complex world, many desperately seek someone who preaches certainty in tidy sound bites, telling tall tales with unwarranted conviction.

But in investing, the future is never certain and forecasting is never easy. Most investors are drawn like moths to a flame to gurus who act as if they know what the future will bring. They ignore cautious, tentative forecasters who speak in terms of probable outcomes.

Why do they do this? In Future Babble: Why Expert Predictions Fail — and Why We Believe Them Anyway author Dan Gardner shows how people are wired to crave certainty. We oversimplify the complex, see patterns where there aren't any and delude ourselves daily. Above all, we want an expert to tell us what the future will bring, especially when it comes to our finances.

Gardner examines forecasts in general and shows why relying on them is usually no better than using a dartboard. Despite this reality, people seek out forecasts — especially from gurus who issue them with shameless certainty, avoiding complexity. People put aside their normal skepticism to follow this advice because their brains are starving for certainty. Believing such predictions instead of considering well-reasoned forecasts satisfies this hunger.

"No matter how often expert predictions fail," Gardner writes, "we want more.... Sometimes we even go back to the people whose predictions failed in the past and listen, rapt, as they tell us how the future will unfold."

Drawing from research on the subject, Gardner says there are two basic types of forecasters: foxes and hedgehogs. He quotes an ancient Greek poem that put it this way: "The fox knows many things, but the hedgehog knows one big thing."

Gurus are hedgehogs because they have one big idea that they dramatize with overbearing confidence. Hedgehog forecasters aren't concerned with uncertainty. Instead, they're single-minded, leading to overconfidence. By contrast, fox forecasters are tentative. They know many things and weigh the future differently. They are comfortable with complexity and uncertainty, even if it means they must answer questions cautiously. Foxes have no problem embracing the concept of probability and admitting they could be wrong.

Since we are naturally averse to uncertainty, the hedgehog forecasts are a siren's song. Though it would be wise to plug our ears and ignore hedgehog forecasts, we listen anyway because hedgehogs give us the certainty we crave.

One thing that empowers hedgehogs is that foxes' forecasts are far from perfect. The difference is that foxes' forecasting process tends to deliver far better results over time. This is why investors may want to incorporate such thinking into their investing strategies.

But forecasts have their uses, with some caveats. In all forecasts, investors should:

• Pay attention to see whether the forecaster oversimplifies or is overconfident. Are they willing to admit they could be wrong or do they act as if they know what the future will bring?