Creating a dependable forecast of the economy is notoriously difficult. Tons of variables connect to each other, so a small change in one factor–say, inflation–can have a domino effect.
But it’s even tougher than that. Classical economics assumes individuals make rational choices designed to maximize their own benefits. The trouble is, as we all know, people don’t always behave rationally. If humans are so motivated by monetary reward, why does a joint study by the University of California, Berkeley and Massachusetts Institute of Technology show that many people would put more effort into a small task as a free favor, rather than one for which they are paid a nominal amount? The emerging field of behavioral economics seeks to answer such questions.
I find that viewing the world through a behavioral lens is simpler and more dependable than attempting to craft complex forecasts with traditional tools. Two key concepts in behavioral economics are mental anchoring and groupthink. When someone has a mental anchor, they believe they are creating a fresh idea or prediction but really they’re clinging to some other notion–an anchor–which may or may not be related. Here’s an example: Ask someone to think of the last four digits of their phone number. Then, have that person guess the birth year of a famous person. People with high phone numbers tend to guess higher birth years than those with low phone numbers.
Groupthink can be just as influential. It occurs when commonly held beliefs become so entrenched that people stop questioning them. I can think of two oft-quoted notions in recent years that turned out to be dangerous groupthink: 1) “The new economy has done away with the business cycle†and 2) “Housing prices have never declined nationwide.†Routinely when groupthink takes over, it is dead wrong.
I believe that both mental anchoring and groupthink are at work today when many so-called experts forecast financial market and economic activity. First, I think too many people are anchored to data
and descriptions from the Great Recession, the market crash of 2008, and the depths we plumbed in early 2009. On Wall Street, analysts are supposed to make predictions about how much money companies will earn, but in creating those estimates they inevitably look back at trough levels. Doing so could cause their forecasts to be too low. The same sort of thinking happens on Main Street, whether it’s because a friend lost his job, a family member’s 401(k) got decimated, or the front-page headlines were shocking and memorable. The groupthink created during the recession was so broad and deep with pessimism that it created the notion that the recovery will be slow and weak.(Continued on Page 2)
Successful investors work hard to avoid groupthink. They free themselves from mental anchors. The worst mental weights in the financial arena are stock market levels. Experts place too much weight on “getting back to Dow 10,000,†or not being able to “sustain 11,000.†What matters to investors are corporate profits and paying a reasonable price for them, not a market index number that happens to have a lot of zeros.
amp_ad_1 ampforwp-incontent-custom-banner ampforwp-incontent-ad3">At Ariel Investments, our research team tries not to fixate on what a company earned a year ago or even three years ago. Rather, our analysts try to figure out a company’s normalized earnings. If you look at the long history of a given company, including peaks and troughs and those times in between, what might that company earn if its operations were standard and the economy was neither too hot nor too cold? That’s the earnings number that matters because it establishes the firm’s long-term history of growth.
We also try to stay away from groupthink. When we examine conventional wisdom, we strive to question it from all angles. Why might it be overly optimistic or pessimistic? What are the holes in this way of thinking?
With all these principles in mind, here’s what I think about the future: The United States experienced a deep and long recession starting toward the end of 2007, one that likely ended in mid-2009. We should not allow the bottom to serve as an anchor. Let’s take a longer-term, historic view. Over the decades, economic growth in the U.S. has trended up at a pretty steady rate with a few kinks during recessions. It doesn’t flatten for a decade at a time or even a few years. Growth is normal and it’s under way.
The groupthink-driven idea that the recovery will be slow and painful also strikes me as overdone. In the past, sharper downturns have given way to stronger recoveries. Fiscal and monetary stimulus has flowed plentifully, and corporate balance sheets are flush, so the recovery should be just fine. Despite–or actually because of–the prevailing pessimism and caution, I am optimistic.
Mellody Hobson is president of Ariel Investments L.L.C., a Chicago-based money management firm serving individual and institutional investors. She is also a regular contributor to ABC’s Good Morning America.