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What a Former US Federal Reserve Chairman Gets Wrong about Risk

Economist Kenneth Arrow was a statistician during World War II. One of his jobs was analyzing weather forecasts made months into the future. The forecasts, he found, were pretty much useless. When he warned his commanders against taking them too seriously, he received a legendary response: “The Commanding General is well aware the forecast are no good. However, he needs them for planning purposes.”

This story is reminiscent of something former United States Federal Reserve Chairman Alan Greenspan shared in his latest book, The Map and the Territory. Greenspan writes about the failures of forecasts, especially those made right before the 2008 financial crisis. But then he offers a defense (emphasis ours):

Forecasting, irrespective of its failures, will never be abandoned. It is an inbred necessity of human nature. The more we can anticipate the course of events in the world in which we live, the better prepared we are to react to those events in a matter than can improve our lives.

The former chairman is well aware the forecasts are no good. However, he needs them for planning purposes.

It seems that even Greenspan gets this exactly backwards, especially in the world of finance. Financial lives are ruined when people take too much risk. And one reason people take too much risk is because they believe in their delusional forecasts, and aren’t prepared to react to events.

Sure, we’d do better if we could anticipate the paths our lives go down. But we can’t. You would not wish upon your worst enemy the track record of professional economists predicting the financial events that really mattered throughout history. Maybe we’ve gotten better at predicting the next jobs report, or anticipating a company’s earnings – although it’s not even clear that’s the case.

But think about the most important events of the last century — those that really changed the course of history. World War 1. The flu pandemic. Banking runs during the Great Depression in the late 1920s. World War II. The baby boom. The Cold War. Oil embargoes. The end of the Cold War. 9/11. Lehman Brothers going bankrupt. It was impossible to forecast these events, because all of them relied on “trivia and accident,” as Dan Gardner put it in his book Future Babble.

Put all of the world’s PhDs in a room in 2007, and they couldn’t have forecast that former US Treasury Secretary Hank Paulson would let Lehman go bankrupt in 2008, because Paulson recounts that the decision was largely made in late-night meetings hours before the collapse. In a world where the most important events can’t be predicted, the more we fool ourselves into thinking that we can forecast, the more risk we expose ourselves to.

The people who are the most successful in finance – whether it’s a professional investor or a passive retiree – are likely not those who make the best forecasts. It’s those who put themselves in situations where they don’t need to rely on forecasts coming true in order to do OK.

Sure, you’ve heard stories about investors who make a big, gutsy call and make a fortune. But those stories often rely overwhelmingly on luck and revert to the mean very quickly. Lasting financial success comes to those who align the odds of success in their favor. That comes from being adaptable and open to change, which is literally the opposite of relying on forecasts.

Here are a few golden rules that people’s financial plan should contain:

1) Your portfolio should not rely on recessions not occurring.

2) Your portfolio should not rely on a recession occurring.

3) Your portfolio should not rely on a crash occurring anytime soon.

4) Your portfolio should not rely on a crash not occurring anytime soon.

5) You should not rely on stocks going up 10% a year for the next 50 years (for what it’s worth, Singapore’s stock market, as represented by the Straits Times Index (SGX: ^STI), has increased in price at an annualised rate of around 5.2% over the past 26 years since the start of 1988).

6) Your expenses for the next six months (at least) should not rely on remaining employed.

7) You should not rely on inflation remaining low.

8) You should not assume the Fed printing money in the USA means hyperinflation is imminent and will be everywhere.

9) You should not rely on making as much money for the rest of your career as you do today.

10) You should not rely on one person’s opinion.

11) You should rely on being wrong, and the future’s biggest news stories being stuff no one is talking about today.

This doesn’t mean you’re not taking risk. It just means that you can handle things that don’t go according to plan. Logically, you’ll never be able to do that completely. But everyone can improve their financial lives by trying to lengthen the distance between your forecast coming true and needing your forecasts to come true. In investing, some of you might know this concept as having a “margin of safety”.

Greenspan is right that forecasting is human nature. It’ll never go away. But the more we convince ourselves that we’re able to forecast with precision, the riskier the world becomes. Humility seems to be what we need to be advocating for, which is rather reasonable after thousands of forecasters — Greenspan included — were humbled.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. This article was written by Morgan Housel and first published on fool.com. It has been edited for fool.sg.