March 18, 2013

The Prediction Paradox

In the summary description of the book The Signal and the Noise: Why So Many Predictions Fail – But Some Don’t, written by political forecaster, Nate Silver, there is a wonderful quote…

“The Prediction Paradox: the more humility we have about our ability to make predictions, the more successful we can be in planning for the future.”

The quote is a great synthesis of why the standard Wall Street approach to investment management fails so regularly and suggests what the better approach might look like.

Wall Street investment advice is built on the premise (false) that clients need to know the future in order to make the right decisions about their investments.  The one-two punch works this way.  First scare clients into believing that they need to know what the future holds or else bad things will happen.  Then come right back with ‘we have the global resources and research to protect you from the bad things’.

Implementing this strategy leads to portfolios constructed on the basis of forecasts (bets) that are much more likely than not to turn out wrong.

The better approach is to begin the process by accepting that the future is unpredictable.  This initial step leads to portfolio construction underpinned by global diversification, low costs, tax efficiency and risk levels appropriate for each client.

The resulting portfolios serve clients well in an uncertain world.