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?

• Remember that even the best fox forecasts are often wrong. If suppositions don't hold, then the forecasts based on them won't either.

• Consider several reasonable forecasts instead of betting the ranch on one.

• Beware of brevity. This is usually a bad sign because behind every solid forecast has a sound framework and a lot of information. If forecasters use too few facts, these facts are more likely to point in the wrong direction. Such forecasts are inclined to see either boom or bust, missing the possibilities in between.

Here are some helpful resources to help you think like a fox:

• Investors.com. This site was started by William J. O'Neil, successful businessman and all-star investor. O'Neil has taught investors to study the market's current conditions before investing, and stresses having the discipline to change your opinion when the market says you're wrong. Instead of guessing what the market may do, O'Neil reacts to what the market is actually doing.

• Economic Cycle Research Institute, the leading predictor of recessions and recoveries. This site includes forecasts and forecasting tools to help you make better decisions.

• CXO Advisory Group. Offerings include earnings and economic forecasts and surveys of a wide array of forecasters. It also rates forecasters and gurus on accuracy.

• Shadow Government Statistics: Analysis Behind and Beyond Government Economic Reporting . This site shows readers how calculation methods for government statistics may change from year to year and how these changes affect forecasting accuracy.

Becoming aware of the complexities involved will help investors suppress their unhealthy appetite for certainty. By taking forecasts with a grain of salt and recognizing when a forecaster is being a hedgehog, you'll be better able to avoid getting sidetracked and to stick to your investing strategy.

Craig J. Coletta cj@cjcoletta.com has 20 years of experience in the financial industry. He is president of C.J. Coletta & Co., a Registered Investment Advisor firm, and president of Coletta Investment Research Inc. Coletta is a Chartered Financial Analyst, a Chartered Market Technician and a Certified Hedge Fund Professional. He holds a B.S. in accounting and business administration from Rider University, and is a member of the American Institute of Certified Public Accountants.