It’s safe to say that octopuses and other sea creatures probably don’t have a particularly strong grasp of the various complexities of human affairs. It’s also quite safe to say that most people realize this; certainly, one can’t imagine that there are too many people turning to these denizens of the ocean depths for insights into matters such as, say, which team is favoured to win a particular sports match. And yet, during the FIFA World Cup in 2010, this is exactly what happened: “Paul the Octopus” briefly became an international sensation for his apparent ability to “predict” various match outcomes. Now, this might seem like a strange way to start a commentary on finance, but there is a good reason for it. Paul the Octopus is really a symptom of a larger flaw in our intuitive reasoning which can cause even highly intelligent people in serious contexts to make misguided predictions.

To be clear, the problem with the hype around Paul the Octopus wasn’t that people actually believed the mollusc to be genuinely psychic, but that they considered the string of successful guesses to be a surprising and unexpected occurrence to begin with. To get a sense of what this means, consider the popularity of the FIFA Soccer World Cup – easily the most-watched, most-followed, and most-talked-about sporting event in the world. And when it comes to upcoming sporting events, one of the most popular topics of conversation is that of predicting who will win. When all is said and done, we look back with the benefit of hindsight (and the media’s selective reporting) and notice those predictions that happened to get it right while ignoring the ones that didn’t. We think of Paul the Octopus as a freak occurrence – not as an expected outcome – and hence attach an unwarranted sense of significance to it. We don’t realize that it would be more unusual if there wasn’t at least one hare-brained scheme somewhere on the planet that correctly predicted the tournament’s results out of dumb luck.

We see similar things happening even in more sober affairs, such as in the realms of economics and politics. Whenever people observe a pattern – for instance, the current state of the economy, or some political trend – they are liable to misdiagnose the reasons for it. Starting with faulty assumptions often results in either overly confident or pessimistic predictions about the future that miss the mark. Even highly knowledgeable people are vulnerable, as demonstrated by the psychologist Philip Tetlock. In his 2005 book Expert Political Judgment, Tetlock describes his study, which evaluated tens of thousands of economic and political predictions made by several hundred experts over the course of two decades. The results were clear: When it came to broad matters like politics or the economy, human predictions (even those made by experts) were practically indistinguishable from blind guesses. It should be noted, of course, that this observation is not a slight against these experts (who no doubt know a great deal about their respective fields), but rather a comment on the inherent unpredictability of such matters.

Perhaps as anticipated, this documented evidence of their lack of success does not appear to have dissuaded the experts – they continue to make confident assertions and will often construct eloquent narratives that make their predictions seem almost inevitable. These stories tend to be superficially plausible and emotionally satisfying – a dangerous combination – and the peddling of such narratives has itself become a huge industry, particularly for talking heads and authors. Trader-turned-philosopher Nassim Taleb makes no attempt to hide his disdain for those who resort to this form of storytelling as a way of appearing credible. In his book The Black Swan, he notes that while they were “much better at narrating – or worse, at smoking you with complicated mathematical models,” they weren’t necessarily better than a layman when it came to making accurate forecasts. Interestingly, these very pundits have now focused their “skills” on predicting the 2014 FIFA World Cup – perhaps a direct challenge to this year’s favourite psychic animal, Brazil’s World Cup turtle.

So if you can’t trust the experts, then who can you trust? Is every facet of human existence a complete game of chance? And where does that leave investors – if the world of finance is similarly unpredictable, are they better off leaving their investment decisions to, say, a dart-throwing monkey?

Fundamental Value Investing

Fortunately, the situation is not that dire; there are methods that investors can turn to that have a proven and meaningful record of success. One prominent example is value investing, a concept that was introduced in the 1920s and has since gained a number of high-profile supporters including the likes of Warren Buffett. The success of value investors has been put under serious scrutiny and has been found to be very sound, even accounting for randomness and the other biases and pitfalls common in such analysis. What sets value investment apart from the kinds of unreliable predictions mentioned earlier is that it entails a focus on concrete information about specific companies, rather than generalized extrapolations based on vague and volatile data.

The strength of fundamental value investing is, oddly enough, the very thing that makes it hard for most investors to swallow. Since it relies not on constructing narratives but rather on carrying out methodical, dispassionate evaluations, it may never have the same emotional appeal as the stories being told to us by well-dressed pundits and talking heads. What we must strive to remind ourselves, though – as hard as it may be – is that our decisions (and particularly our financial decisions) should be guided not by vague feelings, but by pragmatism grounded in empirical fact.

Garnet O. Powell, MBA, CFA

I am honoured to have been able to share with you my thinking on the investment process and would be delighted to hear your thoughts.