How to protect yourself from ‘prediction addiction’; “Prediction addiction” is hard-wired into our brains. The most successful investors resist it

How to protect yourself from ‘prediction addiction’

Comment: “Prediction addiction” is hard-wired into our brains. The most successful investors resist it, says Tom Stevenson

By Tom Stevenson

11:43AM GMT 18 Nov 2013

In a few weeks’ time a Christmas tradition as familiar as brandy butter and tinsel will kick off: the annual round of market predictions. It’s a bit of fun and in a year’s time no one will remember anyone’s forecasts. This is just as well because the one really predictable thing is that most of them will turn out to be horribly wrong.Hardly a day goes by when we are not reminded of the folly of forecasting. Inflation rises less than we expect but employment is up by more; company results are better or worse than forecast; interest rates are cut out of the blue while events that look a racing certainty (Fed “taper”, anyone?) fail to show up. If we can’t get these short-term predictions right, what hope should we have of nailing the longer-term outlook?

We may be doomed to fail but we seemingly can’t stop second–guessing what’s coming next. Our need to gaze into the entrails of the markets – what Jason Zweig, the behavioural finance expert, calls our “prediction addiction” – is hard-wired into our brains. Unfortunately, like many of the deep-seated psychological biases that make us human, this desire to see patterns and extrapolate them into the future can also make us poor investors.

We are programmed to seek cause and effect in random events because for millions of years doing so was a good idea. We learnt the link between our surroundings and the big beasts looking to eat us; we saw the signs of an approaching storm; we understood the visual cues that helped us find food and avoid danger. It is hardly surprising that it is now second nature and kicks in long before we’ve fired up the different, logical thinking we need to be good investors. Modern financial markets have been around for a few hundred years at most.

The second reason we are obsessive pattern seekers is because it makes us feel good. A naturally occurring drug called dopamine floods our brains with a warm glow when we get an unexpected reward like making money on an investment. It’s nature’s way of getting us off our backsides to go out and face life’s risks, out on the trail of our next meal.

Now the interesting thing about dopamine is that our brains don’t just respond to what is happening now but to what we expect to happen in the future. The feel-good drug doesn’t only flood our brains when we make that successful investment, it does so when we think about making it. In particular we feel good when we spot the patterns we think will lead to the next big win.

Another interesting aspect of this dopamine rush is that its strength is determined by how recently we experienced the events we’re seeking to repeat. So our willingness or otherwise to make a new investment is to a large extent triggered by our last few investments. We measure the probability of success not on the basis of long experience but on our last few trades.

This is why investors do silly things towards the end of bull markets. We are so pumped up on success that it is inconceivable that things won’t go on this way for ever. It’s why nearly five years into a bull market you should not expect many experts to be flagging a change of direction this Christmas.

The counsel-of-despair response is that investing is a mug’s game. I don’t think it is because there are practical steps we can all take to limit the impact of all this chemical confusion. What it does tell me, however, is that the person most likely to undermine my investment success is looking back at me from the mirror.

Understanding how much of our investing behaviour is determined by the instinctive, primeval part of our brains and how little by the cool and collected Mr Spock within is an important first step. It’s why it is so important to eliminate the emotion and sentiment from our investments. If it feels good it probably isn’t.

I find the best way to avoid the dopamine curse is to take as much of myself out of the process as I can. That means investing as if I haven’t a clue what’s going to happen next year. This makes sense because, truly, I don’t.

I don’t know whether developed markets or emerging markets will outperform, so I make sure I have some of both. I don’t know whether we are close to the top of the cycle or only halfway up so I invest as much as I can afford every month regardless. In my single stock investments, I stick to some pretty simple valuation rules that prevent me paying too much and stack the odds in favour of a decent return over time. I don’t deal very much.

Now then, where do I think the FTSE 100 will be next Christmas?