At the beginning of a New Year, financial journalists churn out articles about how the markets are likely to perform over the next 12 months. Their sources are often the forecasts published by industry analysts. According to one report published in December 2023, for example, analysts have on average predicted that the value of the S&P 500 will increase by 10.5% in the 12 months to December 2024.
But before we all rush off to bet our life savings on next year’s stock market, it’s worth asking how accurate we are at making these kinds of predictions in the first place. And the answer seems to be: ‘very bad’. Last year, for example, Forbes reported that the ‘consensus view’ of analysts was that the S&P 500 would fall, whereas it actually ended the year up 26.3%.
This isn’t a one-off. Over the past twenty years, industry analysts have on average overestimated the year-end value of the S&P 500 by more than 7%. And this average figure hides the fact that some years the figure is overestimated, in other years it is underestimated.
So why are we so frequently so far off with our predictions?
The first reason is something most human beings suffer from: overconfidence. As several behavioural scientists have shown over the years, many of us tend to overestimate the precision of our beliefs, knowledge and our ability to predict the future. When researchers asked senior financial executives to predict stock market returns with 80% confidence intervals, for example, actual returns were within their intervals only 36% of the time.
We see the same trend when asking people to guess the answers to questions, such as ‘what is the size of the UK economy?’ or ‘how many people live in Brazil?’. Most of us are capable of having a stab at answering these questions, but we tend to be much more confident about the accuracy of our guesses than we deserve to be.
The second is that when making predictions in any field, we have a natural tendency to build our projections based on information which is readily available to us. This makes it hard for us to deal with new developments, such as the rise of Artificial Intelligence, which had a dramatic impact on US markets at the end of 2023.
And it makes it almost impossible to fully account for outlier, ‘Black Swan’ events that can have a truly outsize impact upon financial markets. The effect of a major global pandemic, for example, was factored into very few financial analysts’ predictions in the year to come (despite the warnings of health authorities that an event of this magnitude was possible at some point).
What, then, are we to make of this combination of overconfidence and unexpected developments? From a behavioural perspective, for anyone thinking of making an New Year’s investment, it is wise to adopt at least three maxims: (i) we should not pretend we can predict what is going to happen over the next year, but take a longer-term perspective; (ii) we should spread our bets, rather than assuming that any specific one will pay off; and (iii) we should consider what impact an unexpected event may have on any investment we might make.
If all of this sounds too pessimistic, we would like to leave you with the predictions of one sage financier who always gets his predictions spot on. His prediction this year is the same as it was for last year and the year before that. It is that “the market will probably be up, but it might be down”.
