Since a bit of levity on Friday afternoon never hurts*, we pass along the following anecdote-cum-lesson from The Psy-Fi Blog:
Every morning before he left home the illusionist James Randi used to take a piece of paper and write on it “I James Randi will die today”. He’d then sign and date it and slip it in the pocket of his jacket. Had he died, of course, the world would still be full of credulous believers insisting that he was a genuine psychic seer. We smart investors laugh at such fools, of course.
We shouldn’t, though, because every day we’re the victims of people just as clever as Randi and without any of his good moral sense. Every day, across the world, people forecast the unforecastable and predict that markets will boom, or bust, or stagger sideways like a drunken sailor. Eventually one of their predictions comes true and gullible people everywhere equate this with foresight when, in fact, the forecaster has simply been slipping a note in their pocket each morning. In a world where everyone predicts everything occasionally someone’s going to be right.
Indeed.
FT Alphaville has mentioned the perpetual optimism bias in the forecasts of securities analysts, but we’ve never really heard an explanation for it. Psy-Fi digs up an old study that offers one possible explanation:
Hong, Kubik and Solomon in Security Analyst’s Career Concerns and Herding of Investment Forecasts have proposed an interesting variation of why analyst forecasts aren’t very good in general. Herding – the behavioural trait that causes investors to move in a given direction at the same time – is triggered by career related incentives. This, of course, is not generally a factor for private investors and therefore is often neglected in considerations about why professionals make their recommendations.
What they find is that younger analysts tend to herd more than their more experienced colleagues: less experienced analysts tend to be punished more heavily for getting their forecasts wrong so they have every incentive to stick with the crowd. In contrast older analysts, who have presumably built up their reputations, face less risk of termination. Basically if a younger analyst makes a bold forecast and gets it wrong they’re likely to lose their job, while doing so and getting it right seems to make little difference to their immediate career prospects.
One possibility, then, is that the optimism bias perpetuates itself among the analyst community by steadily increasing the punishment for any single analyst to deviate from it (and be wrong).
That certainly is plausible, but the study doesn’t tell us whether older analysts are any better, as Psy-Fi notes. That doesn’t mean herding is disqualified as a possible explanation, but neither does it settle the matter, obviously.
[*or, we don't feel like working much more today]
Related links:
James Randi and the Seer-Sucker Illusion – The Psy-Fi Blog
Equity analysts have been overoptimistic for a generation – Harvard Business Review
About that Lehman call… – FT Alphaville
The BoE and Central Bank forecasting – FT Alphaville