Thursday, September 9, 2010

Often Wrong, But Never in Doubt

Richard Thaler, New York Times, 8/22/10

"Businesses in nearly every industry were caught off guard by the Great Recession. Few leaders in business — or government, for that matter — seem to have even considered the possibility that an economic downturn of this magnitude could happen.

What was wrong with their thinking? These decision-makers may have been betrayed by a flaw that has been documented in hundreds of studies: overconfidence.

Most of us think that we are “better than average” in most things. We are also “miscalibrated,” meaning that our sense of the probability of events doesn’t line up with reality. When we say we are sure about a certain fact, for example, we may well be right only half the time."

This is a really interesting article about how bad we are at forecasting the future.

"...chief financial officers of major American corporations are not very good at forecasting the future. The authors’ investigation used a quarterly survey of C.F.O.’s that Duke has been running since 2001. Among other things, the C.F.O.’s were asked about their expectations for the return of the Standard & Poor’s 500-stock index for the next year — both their best guess and their 80 percent confidence limit. This means that in the example above, there would be a 10 percent chance that the return would be higher than the upper bound, and a 10 percent chance that it would be less than the lower one.

It turns out that C.F.O.’s, as a group, display terrible calibration. The actual market return over the next year fell between their 80 percent confidence limits only a third of the time, so these executives weren’t particularly good at forecasting the stock market. In fact, their predictions were negatively correlated with actual returns. For example, in the survey conducted on Feb. 26, 2009, the C.F.O.’s made their most pessimistic predictions, expecting a market return of just 2.0 percent, with a lower bound of minus 10.2 percent. In fact, the market soared 42.6 percent over the next year."

One of the interesting omissions of this article is that it never mentions the complexity of the future. It blames the failures on "mis-calibration" and "hubris".

Read the Article

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