The following was authored by Matthew Tufano, economist within Vanguard’s Australian Investment Strategy Group.
I love forecasts. If there’s something to predict, chances are I’m thinking about it. I first caught the “prediction bug” during winter storms, which brought the possibility of school snow days. If I believed it would snow enough to close school and I was right, I’d have an extra day to do my homework. The night before, I’d have to decide how confident I was in my call. Was I confident enough not to finish my assignments?
The reward of being right (and the cost of being wrong)
We’re drawn to forecasting snow, rain, and market activity for the same reason. Being “right” brings rewards—an extra day to catch up on schoolwork, an umbrella to keep you dry, or the possibility of significant financial returns (or shelter from significant market losses). On the other hand, there can be steep costs if we’re wrong—and overconfidence is usually to blame when we err.
For some, the knee-jerk reaction might be to dismiss forecasts altogether—yet having no opinion is an opinion (and can be as big a mistake as overconfidence). Given the possible costs and rewards of making a decision based on a prediction, how are we supposed to plan our financial future, let alone our weekend?
Cloudy with a chance of …
For me, it’s a balancing act. Before deciding, I ask myself: If the forecast doesn’t turn out as I expected, what will I do? Will I regret the decision I made?
Contemplating these tough questions ahead of time, when I’m not in the heat of the moment, prepares me to handle whatever lies ahead. Making decisions based on my long-term goals, time horizon, and risk tolerance—in addition to understanding the current investment climate and what may be coming down the pike—helps me stay calm when others are skittish.
It may be tempting to assume the status quo will continue. But that assumption can be dangerous: Markets are unpredictable and reactive. A small change in the economic climate could trigger the end of one of the longest-running bull markets in the U.S. since the Great Depression.
The political climate and recent market volatility can make it very tempting to change your portfolio. But before reacting, weigh any change you’re considering against the costs of being wrong. If you don’t do your schoolwork in anticipation of a snow day and school remains open, are you ready to accept the consequences of being unprepared for class? If you abandon your asset allocation in pursuit of safer investments and the market doesn’t drop, are you comfortable missing out on market returns? (And will you know when to get back into the market?)
Market volatility isn’t something we, as investors, can control. But each of us controls our investment plan. Think of it like an umbrella—you appreciate it most when you don’t have it.
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