Investment experts, economists and industries are more prone to making predictions during the New Year, given the renewed sense of focus and excited anticipation for what lies ahead, so often synonymous with the start of a new season. You may too begin to predict what you think will happen to the economy, and then (falsely) extend this to your investments. But making predictions can thwart your success as an investor.
How bad predictions hurt you
We make prediction mistakes in at least two ways: by extrapolating the recent past, and by mistaking logical patterns. We may wrongly extrapolate that an investment award this year means a unit trust will continue to perform as well next year: statistically, last year’s short-term winners are more likely to be next year’s losers. We may wrongly think that strong Gross Domestic Product (GDP) growth means higher future investment returns: statistically, GDP growth and investment returns are almost entirely uncorrelated.
We are vulnerable to these errors because we don’t have the time to get to all the facts, so we take shortcuts, placing too much value on our gut feeling or the casual opinions of friends. This even applies to an investor in something like a unit trust, where the investment decisions are made by a professional fund manager – because of the temptations of switching. Moving your investment from a recent poorly performing unit trust into a recent top performer and then back again after the previous winner does badly, is a common drag on returns.
Guidelines for better decision-making
Using the following three steps can help you consider the quality of your predictions so that you do not make rash choices.
1. Establish the facts behind the prediction
In a world saturated with information, it is remarkable that decisions often come from a factless basis. It is not enough to assume that market commentators or your friends have done their homework when it is your money that will be affected by the decision you make. It is equally important to resist the strong temptation to cherry-pick information that confirms your view.
2. Consider the motivations of the source
If a prediction is made by a news source that is ideologically required to colour its coverage in positive upbeat tone or a negative bearish shade, this may compromise that prediction. More importantly, you need to consider your own psychology. Are your emotions predisposing you to think in a certain way? Merely acknowledging your own emotional state can help you take it into account.
3. Consider the opposite
What if your prediction is wrong? Whatever decision you make should account for a range of outcomes. When professional portfolio managers construct a portfolio, they normally try to combine investments that have different risks and upsides, so that if one performs badly, the other may perform well, or will at least not be impacted.
The future is unknowable and beyond our power, but we do have the power to choose how we respond to it in the decisions we make. The choice is yours.