The perils of investor overconfidence
All that can be said with modest confidence is the economy’s path has indeed changed.
Economists and investment strategists are said to suffer from a malady known as “physics envy.” The physical universe is governed by laws that create certainty about the outcome of an action. If a ball is released from a roof, it will fall to Earth every time due to the law of gravity. In economics and finance, no laws exist. Only econometric models are available, and none of them rival the laws of physics as forecasting tools.
In most cases, econometric models attempt to make sense of historical data by identifying what look like relationships between variables. When A happened, B followed. If a relationship is real and persists, current data indicate what will happen in the future. But what looks like historical relationships are often mere coincidences within randomness. Sadly, that means all economic and financial market forecasting is a low-confidence endeavor, even under the best circumstances.
Physicists use laws that guarantee future outcomes. Envious economists and investment strategists use models that leave the future shrouded in ambiguity. This can be unsatisfying, so many of them inappropriately present their forecasts with physics-like certainty. We’ve seen a lot of that lately.
continue reading »