Financial Freedom

Two Simple Rules to Win the Prediction Game

  • Humans have tried every method imaginable to predict the future, from reading tea leaves to performing complex data analysis.
  • These efforts are futile, but Nicholas Vardy shares two simple things you should actually do to build wealth and win the prediction game.

Humans are a funny lot.

In ancient times, the people of Mesopotamia predicted the future using haruspicy – the reading of animal entrails.

My grandmother scanned the astrology section of the newspaper every morning.

Today, investors try to predict markets by surveying the financial media.

The irony is this: No matter how carefully we try to divine the market’s future by reading our favorite investment guru, our predictions are no more reliable than those of the priestess at the Oracle of Delphi were for the Greeks.

This insight leads to a pair of counterintuitive lessons relevant to investing. First, keep your decision making process simple. Second, focus on protecting your downside.

I’ll explore these two lessons below.

High-Profile Flops in Prediction

Recent history is littered with financial predictions that never came to pass.

Just consider the past decade…

In 2011, economists warned that the economy was on the verge of spiraling into another Great Depression.

Gold bug Peter Schiff predicted gold would hit $5,000 an ounce by 2012.

On November 27, 2011, Financial Times columnist Wolfgang Münchau predicted that “The eurozone has 10 days at most.” That would have signaled the collapse of the European Union.

The world turned out very differently.

The second Great Depression never happened.

Gold barely nudged above $2,000, let alone $5,000.

And not only did the eurozone and European Union remain intact, but their biggest “problem child” – Greece – is now issuing debt at negative yields.

These misfired predictions hurt investors’ portfolios.

The doom-and-gloomers promised to “crash-proof” their clients’ portfolios with investments in gold and foreign markets. They should have stuck with investing in simple U.S. index funds.

Rule No. 1: Keep It Simple

So how can you improve your investment decision making?

First, keep it simple.

This advice flies in the face of conventional wisdom on Wall Street. That’s because Wall Street thrives on complexity.

I blame the rise of spreadsheets and quantitative investing. Financial analysts insist that the more complex the financial model, the more accurate its predictions.

But let me share the dirty little secret of financial analysis… Any financial analyst worth his or her salt can build a model to justify almost any valuation.

Want proof?

Less than two months ago, Goldman Sachs placed a valuation of $96 billion on office rental giant WeWork. Today, WeWork is valued at about $8 billion. And it’s on the verge of bankruptcy.

Enter the fundamental insight of psychologist and former University of Chicago professor Gerd Gigerenzer. He argues that “fast and frugal decision making” trumps complicated predictive models every time.

Goldman Sachs’ elaborate models are more wrong more often because they are so complicated.

Gigerenzer offers the example of how an outfielder in baseball makes a decision. To model how an outfielder catches a ball requires calculus.

But an outfielder doesn’t do calculus in his head in deciding where to run to catch a fly ball. Instead, he uses “fast and frugal decision making” – that is, he keeps the angle of the ball in relation to his line of sight constant.

In the same situation, the Goldman Sachs analyst would build a model – and drop the ball.

Rule No. 2: Protect Your Downside

Last week, I wrote about my prediction of a Q4 rally in the U.S. stock market.

So am I not throwing stones in glass houses by making such a prediction? Perhaps I am.

But here’s the difference…

I know that predictions – whether “fast and frugal” or otherwise – matter little in profitable trading.

Limiting your downside when you are wrong is far more important than the specifics of any investment recommendation. That’s why The Oxford Club places a 25% stop on almost all of our recommendations.

It’s a simple rule. And it also explains why aphorisms like “cut your losses and let your profits run” beat predictive statistical models.

As George Soros, the grandfather of modern speculators, observed, “My system doesn’t work by making valid predictions. It works by allowing me to recognize when I am wrong.”

Good investing,

Nicholas

P.S. I’m watching the documentary Roman Empire on Netflix. It offers an entertaining glimpse into the lives of some of Rome’s greatest emperors, including Julius Caesar, Caligula and Marcus Aurelius.


Interested in hearing more from Nicholas? Follow @NickVardy on Twitter.


About

A widely recognized expert on the exploding asset class of exchange-traded funds (ETFs), Nicholas has been a regular commentator on CNN International and Fox Business Network. He has also been cited in The Wall Street JournalFinancial TimesNewsweek, Fox Business News, CBS, MarketWatch, Yahoo Finance and MSN Money Central. Nicholas holds a bachelor’s and master’s degree from Stanford University and a J.D. from Harvard Law School. It’s no wonder his groundbreaking ETF content is published regularly in the free daily e-letter Liberty Through Wealth.

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