Wisdom From Jason Zweig – Fat Tails, Thin Ice


On “Past performance does not guarantee future performance”

Future outperformance of stocks is far from the sure thing that many financial advisors pretend that it is.

Warned financial advisors not to extrapolate the past into the future.

Certainty is every investor’s worst enemy. The only universal truth that the past offers about the markets is that they will surprise us in the future.

One thing we can forecast clearly is that, if the past is any guide, the future won’t resemble it.

On market forecasting and predictions

Advisors are dangerously naive in the way they market their abilities.

… to acknowledge the inevitability of surprise.

Markets will most brutally surprise those who are most certain what the future holds.

Being right is the enemy of staying right—partly because it makes you overconfident, even more importantly because it leads you to forget the way the world works.

If you have centered your practice on your ability to forecast markets…then you have positioned yourself on thin ice in a world of fat tails.

On financial planning practice

Their fees need to come down.

Financial-planning industry is full of people busily identifying market “patterns” that aren’t even there

Now how many of you are prepared to take your own fees based on whether you succeed in picking benchmark-beating managers? If you believe you can identify superior funds, why don’t you charge accordingly? If you rightly admire managers for taking this courageous step, why won’t you do it yourself? I’m bewildered by this inconsistency, and the investing public is slowly getting wise to it.

So you need to define your clients’ goals, and the means you propose to help them get there, not only in terms you both can understand, but in terms that mean the same thing to you and to your clients.

Next, help your clients track their own forecasts. With all that whiz-bang software of yours, offer to set up a virtual kind of paper portfolio for them. The trick is to make sure someone can input each and every investment idea your clients get; naturally, the more ideas they have, the worse their returns will be. By showing them that, you will do them a real service.

I’d ask you to stop building your practice entirely around the doomed effort to predict what the markets will do, and to devote less of your energy to designing portfolios that might prosper if those predictions somehow happened to come true. Instead, build your practice around understanding your clients better and explaining to them exactly what is knowable and what is not. You shouldn’t just admit your limitations; you should embrace them. You are in the blessed position of being able to understand your clients better than they may be able to understand themselves—as long as you listen to them and speak the truth to them, including the truth about your own blind spots, in terms they can understand. By forgetting about forecasting, you can try to control the things that are controllable.

On Normal Distribution

But the belief that the markets are built on a bedrock of normality is nothing but sand.

On Optimization and Models

And if the unprecedented is lurking out there, just waiting to show itself at the most improbable—if not unimaginable—moment, then where does that leave your optimizers? What good are your Monte Carlo simulations?

No matter how many times you reshuffle the past in your Monte Carlo machinery, you’re still drawing from the past to predict the future.

On Risk

Communicating risk is notoriously tricky.

All too many of you still think you can determine your clients’ risk tolerance primarily with a multiple-choice questionnaire. That’s just not enough.

On Psychology

I spent my first five or six years in financial journalism laboring under the false notion that investing is driven by economics. Finally I learned that it’s driven, instead, by psychology and history. And the most important thing psychology tells us is that people learn almost nothing from history.

Paper: Fat tails, Thin ice

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