Scan any newspaper in any part of the world, and you always see disaster looming on the horizon. In the financial world, economists are often accused of predicting 10 of the last seven recessions. But the pessimism of the practitioners of “the dismal science” pales in comparison to the predictions of doom and gloom in the world’s media.
The world, it seems, is always on the verge of coming to an end. I remember my second grade classroom had dozens of copies of Stanford professor Paul Ehrlich’s “Population Bomb”, which predicted that hundreds of millions of people would starve to death in the 1970s and 1980s. Think of all the apocalyptic predictions just over the last decade — AIDS, Y2K, and the SARS virus. I remember reading a headline in London in 2003 about a study that predicted that 50,000 people would die from “mad cow disease” in the United Kingdom alone — just about as many Americans died in the Vietnam War. This past summer, physicist Stephen Hawking wanted to hold an “end of the world” party upon the launch of the European Large Hadron collider, which some had predicted “could destroy the Universe.” But Hawking wisely held off, assuming the media would misinterpret his tongue in cheek exercise.
History is littered with experts who predicted the end of the world — and got it wrong. In today’s London Financial Times, Michael Spinaker quotes the philosopher Bertrand Russell, who predicted in April 1961 that if the great powers did not change their policies, “it is in the highest degree improbable that any of you here present will be alive 10 years hence.” At that same forum, Russell also quoted an article by an overconfident albeit gloomy C.P. Snow who noted that: “Within at the most 10 years, some of these bombs are going off. I am saying this as responsibly as I can. That is a certainty.”
The World Will Only End Once: Why Did Experts Get it So Wrong?
The Greeks turned to Oracles to predict the future. In Roman times, soothsayers read animal entrails. These days, the experts we turn to tend to be Nobel Prize-winning economists and academics. While we may smile at the Greeks and Romans, the irony is that thinking you know, too much — about, say, “scientific” financial engineering — only gives you more misplaced self-confidence to screw up and to do so in a much bigger way. The most sophisticated hedge funds in the world invested with Bernie Madoff, their psychological denial triumphing ostensibly sophisticated financial understanding.
So why are we so bad at prediction, even as we are psychologically addicted to it? The world is a complex place. And the elephant in our collective psychological room is that the future is impossible to predict. Psychological studies have shown that few things can drive you nuts faster than the feeling that you’ve lost control. That’s why we also tend to seek patterns where no such patterns exist (like technical analysis), as well as to confirm our pre-existing beliefs (what psychologists call “confirmation bias.”). We gain psychological solace from an explanation — whether it has any basis in truth or not.
It takes exceptional self-confidence to argue against ideas that both made people rich and won their progenitors a fistful of Nobel Prizes. Even in the face of overwhelming evidence, like the disgrace of “modern finance” as a risk management framework in 2008, we’d rather cling to widely accepted explanations even when experience suggests they may be wrong. And this tendency applies to supposedly “objective” areas like science. It took the Roman Catholic Church until October 31, 1992, to concede that the Earth was not stationary as Galileo had argued in 1633. You can only hope that today’s business school textbooks espousing modern finance will move more quickly.
The World Will Only End Once: Does It Even Matter if You’re Right?
Here’s what’s even more distressing. It doesn’t seem to matter whether the experts got it right or wrong. There were, of course, a handful of Cassandras who predicted correctly that subprime lending, securitization and financial engineering would end in disaster. Yet it’s unclear how many of these Cassandras profited from their accurate insights.
While virtually all of the Cassandras who warned about imminent collapse of the U.S. real estate market and the historic implosion of Wall Street’s greatest financial institutions analyzed the problems correctly, their recommendations to protect you from the coming catastrophe have mostly gone terribly wrong. Prior to the onset of the crisis, the Cassandras boasted that their advice would “crash-proof” your portfolio. Yet the foreign markets they recommended, whether China, Brazil, Russia or Japan, offered no safe haven. The commodities markets in which they parked their money tanked even worse. And instead of collapsing, the much-reviled U.S. dollar — the Cassandras’ metaphor for American decline — replaced gold as the ultimate safe haven in times of crisis.
And does “getting it right” really make them smart or insightful? The answer is more ambiguous than you’d think. Consider the case of the top-performing financial newsletter of 2008, Arch Crawford’s Crawford Perspectives, which gained 42.4% through December of this year. Crawford’s winning strategy? Technical analysis leavened by a liberal dose of astrology. Yes, chart reading and star gazing beat Nobel Prize-winning modern financial theory in the toughest year in recent financial memory. In case you’re wondering (and I know you are), Crawford is cheerfully optimistic about the stock market, predicting an explosive year-end move which should extend well into January. Then, after a corrective phase into late February, he predicts a much stronger and more lasting advance.
The World Will Only End Once: What Is To Be Done?
So how should this impact the way you manage your portfolio? Top traders (and not just lucky ones) know that during times of uncertainty, it’s best to pull in your horns, and bet selectively on a handful of ideas until the dust settles. As George Soros pointed out in his recent congressional testimony, thousands of hedge funds forgot the #1 rule of hedge fund investing: “Don’t lose money.” While that advice turned Soros into a billionaire, it’s too simple to win him a Nobel Prize. Yet common sense trumps complexity yet again.
Here is a final thought for you to consider over the holiday season until The Global Guru returns in 2009 after taking a holiday break next week:
“Don’t worry about the world ending today. It’s already tomorrow in Australia.”