What is expert advice worth on the stock market?
In the sixth century B.C.E., the Chinese philosopher and poet Lao Tzu made a timeless statement: "Those who have knowledge don't predict. Those who predict don't have knowledge."
Well over 2,000 years later, it has yet to be better said. Yet the business press never tires of printing predictions by economists and other market animals. At what pace will the economy grow next year? In two years and in three? Whence stocks, up, down or nowhere special? These are common questions and the analysts generally stand tall and answer them with remarkable authority and confidence.
How seriously should you take their forecasts? Does an understanding of economics and the capital market give you tools to peer into the future?
A paper by psychology professors Gustaf Torngren and Henry Montgomery of Stockholm University - "Worse Than Chance? Performance and Confidence among Professionals and Laypeople in the Stock Market" - demonstrates that Lao Tzu nailed it on the head.
The professors conducted two separate tests, each taken by two sets of people: stock market professionals and laypeople. The stock market professionals included portfolio managers, investment advisers, analysts and brokers with an average of 12 years' experience in the markets. The group of laypeople consisted of ungraduate psychology students.
Each respondent received a questionnaire with the names of two well-known companies on the Stockholm stock market. They were told the companies' names, sector and monthly returns over the last 12 months and were asked to predict which stock would gain more next month.
About half the laypeople in both groups (50% and 52%) got it right, which is statistically sound - after all, in the short range of a month, share prices behave randomly. You'd have received the same result by chance if you'd tossed a coin.
The problem is that among the professionals in both groups, only 40% got it right.
In other words, in both tests, a coin toss would have served you better than the market experts.
The respondents were also asked to rate themselves: What was the probability that they would correctly identify which stock rose more?
One might have expected the experts, who know all about the random behavior of stocks in the short run, to estimate their ability at 50%. But both groups overestimated their skills and thought the probability they'd be right was greater than 50%. The financial experts were a lot more overconfident than the laypeople, by the way.
In the first test, 58% of the laypeople thought their prediction would be right. In the second test that figure edged up to 59%. Among the two groups of analysts, those figures were 63% and 67%.
So on the one hand, the financial experts did worse than the laypeople in predicting which of the two stocks would outperform in the next month. On the other, they were unreasonably confident - given their experience in the marketplace - that they'd get it right.
In fact, what interested Torngren and Montgomery wasn't the forecasting abilities of the respondents in the various groups. The emphasis was on their overconfidence and the factors underlying it.
To elucidate the underlying elements of overconfidence, the questionnaires listed four factors that could have affected the respondents' forecasts: the information they were given on the stocks' past performance, information they already had about the two companies, intuition and guesswork. After having answered the first set of questions, the respondents were asked to rank the importance of these four elements, from 0 to 100.
The results demonstrate substantial differences in approach between the market experts and the laypeople. Both ascribed the greatest importance to "more knowledge" - the first group of respondents graded that 65.5 on average, a figure that rose to 76 in the next group.
The second most important factor underlying the forecasts among financial experts was "intuition." The experts all but ignored "past performance" and "guesswork."
But the two groups of laypeople ascribed great weight to guesswork (an average mark of 67 in the first group and 76 in the second group). Behind that came past performance.
Unlike the financial experts, the laypeople didn't think they had any relevant additional knowledge, so they gave it the lowest ranking.
Now let's look at the big picture the two professors' paper paints.
It's fascinating. The psychology students who participated in the study had little pretensions about their ability to predict changes in share prices.
Most chose to guess the result, so they succeeded about half the time.
The financial experts had confidence on their side and thought they could gaze into the future, assuming that their experience and knowledge would give them an edge. Yet their forecasts were inferior to a coin toss.
What's the moral of the story for investors? The next time you read in the paper about some economist or other analyst predicting the future, remember the wise words of Lao Tzu. The future is unpredictable, dear reader. Neither you nor they know how to read it.
The writer is editor of the Web site Inbest.