This post by Joachim Klement was originally published on CFA Institute's Enterprising Investor.
The nice thing about being an investor is that the forces that drive the markets change all the time. However, there are different “market regimes” in which a major narrative dominates market action.
Over the last 20 years of my career, there have been several ascendant market narratives: technology companies revolutionizing the world, followed by the “jobless recovery” of the early 2000s, and then the “Great Moderation” a few years later. Suddenly in 2007, we all had to become experts in housing and mortgage markets as subprime mortgages blew up the world.
Then it was back to central bankers and such unconventional monetary policy as quantitative easing (QE) and “Operation Twist” that created a “new normal.” Then came the European debt crisis and austerity, which was replaced in recent years by geopolitics and the rise of populism.
And while I am generally skeptical that individual geopolitical events will have a lasting influence on financial markets, there are clearly circumstances — the US–China trade war or Brexit, for example — that can and do have a material influence on investments.
The challenge then is how to forecast these events and their impact. For forecasting rules, the gold standard is described in Dan Gardner and Philip Tetlock’s Superforecasting — a mandatory read for anyone who forecasts. But there are other great resources, including Steve LeVine’s 14 rules.
Personally, I have created my own set of 10 rules that I try to use as guidance when forecasting economic or political events:
1. Data matters.
We humans are drawn to anecdotes and illustrations, but looks can be deceiving. Always base your forecasts on data, not qualitative arguments. Euclid’s Elements was one of the earliest texts on geometry, yet none of its oldest extant fragments include a single drawing.
- Torture the data until it confesses, but don’t frame the data to the story. The data-mining trap is easy to fall into.
- Start with base rates. The assumption that nothing changes and that an event is as likely in the future as it was in the past is a good starting point, but not the end point. Adjust this base rate with the information you have at the moment.
2. Don’t make extreme forecasts.
Predicting the next financial crisis will make you famous if you do it at the right time. It will cost you money and reputation at all others. Remember that there are only two kinds of forecasts: Lucky and wrong.
3. Reversion to the mean is a powerful force.
In economics as well as politics, extremes cannot survive for long. People trend toward average, and competitive forces in business lead to mean reversion.
4. We are creatures of habit.
If something has worked in the past, people will keep doing it almost forever. This introduces long-lasting trends. Don’t expect them to change quickly even with mean reversion. It is incredible how long a broken system can survive. Just think of Japan.
5. We rarely fall off a cliff.
People often change their habits in the face of a looming catastrophe. But for that behavioral change to occur, the catastrophe must be salient, the outcome certain, and the solution simple.
6. A full stomach does not riot.
Revolutions and uprisings rarely occur among people who are well fed and feel relatively safe. A lack of personal freedom is not enough to spark insurrections, but a lack of food or water or widespread injustice all are. The Tiananmen Square protests in China were triggered by higher food prices. So too was the Arab Spring.
7. The first goal of political and business leaders is to stay in power.
Viewed through that lens, many actions can easily be predicted.
8. The second goal of political and business leaders is to get rich.
Combined with the previous rule, this explains about 90% of all behavior.
9. Remember Occam’s razor.
The simplest explanation is the most likely to be correct. Ignore conspiracy theories.
10. Don’t follow rules blindly.
This applies to these rules as well as all others.
