In his award-winning book, The Laws of Wealth, behavioral psychologist Daniel Crosby explains the psychological pitfalls facing investors, plus he offers practical advice for avoiding those pitfalls and improving returns.
 
In this excerpt, Dr. Crosby documents the poor history of stock market forecasters who rely on forward-looking models, and explains why relying on them generally leads to poor results. The solution? Diversify and stay the course.

Our track record in figuring out significant rare events in politics and economics is not close to zero; it is zero. – Nassim Taleb, author of The Black Swan: The Impact of the Highly Improbable.

Perhaps we have had little collective success in forecasting the “rare events” studied by Taleb, but what about the track record of more mundane types of financial forecasting? This is important knowledge because, as James Montier asserts, between 80% and 90% of active investment managers make their decisions on a forecast-based model.

Famed investor James O’Shaughnessy describes the process as so: “Most common is for a person to run through a variety of possible outcomes in his or her head, essentially relying on personal knowledge, experience, and common sense to reach a decision. This is known as a clinical or intuitive approach, and it is how most traditional active money managers make choices.... This type of judgment relies on the perceptiveness of the forecaster.” It all sounds sensible enough, until you realize that we are relying on the perceptiveness of forecasters that, as a whole, are not at all perceptive.