The frailty of forecasting.

Some days it seems as if the world is divided into two groups, those who forecast that the DJIA will soar to 36,000 very soon and those who forecast, with equal confidence, that it will plummet to 3,600. We argue that forecasters often exaggerate the reliability of their forecasts, and trace this exaggeration to the illusion of validity.

“People are prone to experience much confidence in highly fallible judgment, a phenomenon that may be termed the illusion of validity,” write Kahneman and Tversky [1973]. “Like other perceptual and judgmental errors, the illusion of validity persists even when its illusionary character is recognized” (p. 249).

We discuss five cognitive biases that underlie the illusion of validity:

• Overconfidence,
• Confirmation
• Representativeness
• Anchoring &
• Hindsight.

We use forecasts based on P/E ratios and dividend yields to illustrate the biases and offer remedies.

• Click here to download the report

Editor’s Note:

This is an award winning research paper by Kenneth L. Fisher, which discusses futility of market forecasts. It was published in Fall 2000 issue of The Journal of Portfolio Management.

Please note that the figures published in this report are of the U.S. markets but the insights provided in it are applicable to every capital market.