Forecasting Your Emotions

“People who rely heavily on forecasts seem to think there’s only one possibility, meaning risk can be eliminated if they just figure it out.” – Howard Marks

In his classic Apprenticed Investor series for TheStreet.com, Barry Ritholtz shared his thoughts on the folly of forecasting:

Unfortunately, investors all too often give these “predictions” in print or on TV far more weight than they should. It’s very easy for a confident-sounding analyst, fund manager or professor to say something on TV that can throw off the best laid plans of investors.

The bottom line is that I’ve yet to find anyone who can accurately and consistently forecast the market behavior with any degree of accuracy, beyond short-term trend following. That inconvenient factoid never seems to dissuade the prophets — or the press — from their fortune-telling ways.

This was a great lesson for me early on in my career in the investment business. More recently, Howard Marks touched on the same topic in his latest memo:

It seems most people in the prediction business think the future is knowable, and all they have to do is be among the ones who know it. Alternatively, they may understand (consciously or unconsciously) that it’s not knowable but believe they have to act as if it is in order to make a living as an economist or investment manager.

As Marks has stated in the past, “You can’t predict. You can prepare.” As market volatility has picked up over the past couple of weeks, now is a  perfect time to consider these sentiments.

Intelligent investors understand that it’s foolish to base a process exclusively on their ability to predict the future with any certainty. It just introduces so many biases that it becomes self-defeating. Even if you know exactly what’s going to happen with the economy or geopolitical events, the markets aren’t conditional. There’s no if X happens, then Y must follow.

The challenge for investors is that you have to position your portfolio to take advantage of the future even though it’s impossible to predict. Thus, managing a portfolio with a risk target in mind as opposed to a return target is an important distinction.

No one can predict why the markets will rise and fall. There are intellectual-sounding reasons, but no one really knows why the market shrugs off some news but reacts violently to others.  The reasoning always matters less than how you react.

In many ways, investing is really about forecasting your future emotions, not predicting where interest rates or the stock market will go. You then structure your portfolio accordingly. This is why asset allocation is so important. If you know you can’t handle extreme volatility, you should own fewer stocks in your portfolio. It’s why defining your time horizon and risk profile for any investment decision matters so much.

Forecasting your emotions also means incorporating decision trigger points within your plan. Things like how and when you will make buy and sell decisions and how much of your process needs to be automated to control for bad habits.

The issue is that our risk tolerance is constantly evolving based on past experiences and the present situation. It’s much easier to predict what we would have done with the benefit of perfect hindsight than to forecast how we’ll react to a new market environment.

Some people are willing to admit their limitations and hire an advisor to help them forecast their emotions. Others are able to impose constraints on themselves to ensure good behavior.

Either way, a portfolio should be constructed take into account both your past, present and, most importantly, future tolerance for risk. That way whatever happens, you increase the odds that you’ll be able to stick with your process, whatever it may be. You’ll never be able to completely nail it. Perfect portfolios don’t exist.

Ritholtz and Marks both agree that the use of probabilities in any decision is one of the best way to manage risk because it allows you to consider different possibilities and the fact that you will be wrong at times. Hopefully this decreases the chances that you’ll be shocked or surprised by any market outcome.

In many respects, a probabilistic framework on the markets makes forecasting the future secondary to forecasting yourself.

Sources:
Risk Revisited (Oaktree)
Apprenticed Investor: The Folly of Forecasting (The Street)

Now for my favorite reads of the past week:

• Turney Duff with 10 outrageous stories of Wall Street excess (CNBC)
• Are stocks and bonds good enough to construct a portfolio? (Reformed Broker)
• Diversification sucks (Bason)
• A template for the next market crash (Novel Investor)
• The secret tool for today’s financial advisors to succeed (ETF.com)
• Are you a performance taker or seeker? (Rick Ferri)
• Your five year forecast is a joke (Big Picture)
• Net worth is about time, not money (AARP)
• 8 lessons from Jim Harbaugh on leadership and more (Exploring Markets)
• The problem with long-term thinking (Morgan Housel)
• Investment success is found in the quality of your decisions (Adam Grimes)
• The world’s most common misconceptions (Information is beautiful)

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