On Magical Thinking And Investing*

February 28, 2012

Freedman provides a great example of how people react to advice. He presents the case of an individual with back pain, who visits two doctors. Each reviews the patient’s MRI. The first doctor states that he’s seen many similar cases and that it’s hard to say exactly what is wrong. It’s hard to predict what will work for any one person. He suggests they try Treatment A first, and then go on from there. The second doctor states that he knows exactly what is wrong and what to do. Which doctor to choose? Almost always people will choose the latter. Yet, that might very well be the wrong choice. While we want certainty, it rarely exists, and it certainly doesn’t exist in the investment world, where so much of returns are explained by unforecastable events such as Mideast revolutions, Japanese earthquakes and tsunamis, the attack on the World Trade Center buildings, etc.

Foxes And Hedgehogs
Most of us want certainty, even when we know, logically, that it doesn’t exist. With investing, it is a desire to believe there’s someone who can protect us from bear markets and the devastating losses that can result. Yet, political scientist Philip Tetlock demonstrated in his outstanding book, “Expert Political Judgment: How Good Is It? How Can We Know?”, that even professional economic forecasters don’t make accurate forecasts with any persistence.

Tetlock found the so-called experts who make prediction their business—who appear as experts on television and talk radio, are quoted in the press, and advise governments and businesses—are no better than the proverbial chimps throwing darts. He divided forecasters into two general categories: foxes who draw on a wide variety of experiences and for whom the world cannot be boiled down to a single idea; and hedgehogs who view the world through the lens of a single defining idea. The following are some of Tetlock’s most interesting findings:

  • What distinguishes the worst forecasters from the not-so-bad is that while hedgehogs are more confident, they are wrong more often than foxes. Unfortunately, overconfidence is an all-too-human trait.
  • Optimists tend to be more accurate than pessimists. Keep this in mind the next time you read a doomsday forecast.
  • What experts think matters far less than how they think. We are better off turning to the foxes who know many little things and accept ambiguity and contradiction as inevitable features of life rather than turning to hedgehogs who reach for formulaic solutions to ill-defined problems.
  • Experience, profession and privileged information make virtually no difference to a forecaster’s accuracy. The only predictor of accuracy was fame, which was negatively correlated with accuracy: The most famous—those more likely feted by the media—made the worst forecasts.
  • In general, subject matter expertise translates less into forecasting accuracy than it does into overconfidence—and the ability to spin elaborate tapestries of reasons for expecting “favorite” outcomes.
  • Like ordinary mortals, experts fall prey to the hindsight effect—they claim they know more about what was going to happen than they actually knew before the fact. This systematic misremembering of past positions may look strategic, but the evidence indicates that people sometimes truly convince themselves that they “knew it all along.” Hindsight bias causes overconfidence.
  • The “market place of ideas” can fail because consumers may be less interested in the dispassionate pursuit of truth than in buttressing their prejudices.


One of my favorite sayings is that there are three types of investment forecasters: those who don’t know where the market is going; those who know they don’t know; and those who know they don’t know but get paid a lot of money to pretend they do. In other words, they are playing an entirely different game.

The lesson we should take from the research is that we should be wary of so-called expert advice. David Freedman cautions to be wary of advice that has the following characteristics:

  • Is clear-cut, free of doubt and actionable;
  • Is universal, a one-size-fits-all solution;
  • Upbeat and palatable; and
  • Filled with dramatic claims and stories, and specifically numbers that add an illusion of precision.


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