Reading 12: The Folly of Forecasting: Ignore All Economists ego

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 3: Behavioral Finance
Reading 12: The Folly of Forecasting: Ignore All Economists, Strategists, and Analysts
LOS b: Explain the ego defense mechanisms that forecasters rely on as justification for inaccurate forecasts.

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According to behavioral finance, forecasters often make excuses for their inaccurate predictions. Which of the following best represents the problem with this occurrence, from a behavioral finance view?

A) Other investors depend on these forecasts, resulting in aggregate investment losses.

B) Long-term macroeconomic growth suffers as a result of the inaccurate forecasts.

C) The excuses will prevent investors from recognizing their own limitations.

D) The excuses allow poor forecasters to stay in their positions when they should be replaced.

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Answer and Explanation

According to behavioral finance, forecasters often make excuses for their inaccurate predictions. The excuses will prevent investors from recognizing their own limitations and allow them to continue to make inaccurate forecasts. Although there is an element of truth in the other responses, they are not the central problem in this case, according to behavioral finance.

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Maribel Marcos is an economist for Cumulus Investments. She makes monthly forecasts for consumer confidence and business inventories. Last month, consumer confidence was higher than Marcos expected. Marcos explains that her forecast was inaccurate by stating The fact that I was slightly off in my prediction for consumer confidence is not a problem for our clients. After all, I recommended that they move into stocks because I had predicted an increase in consumer confidence, albeit lower than actually occurred. Which of the following is the best interpretation of Marcoss statement, from a behavioral finance view? Marcos is using:

A) a correct direction defense for her inaccurate forecasts and this will facilitate more inaccurate forecasts on her part.

B) a correct direction defense for her inaccurate forecasts and her recognition of it will sharpen her abilities.

C) an almost right defense for her inaccurate forecasts and her recognition of it will sharpen her abilities.

D) an almost right defense for her inaccurate forecasts and this will facilitate more inaccurate forecasts on her part.

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Answer and Explanation

Marcos is using an almost right defense for her inaccurate forecasts. According to behavioral finance, investors will use excuses to justify their inaccurate forecasts. These excuses will prevent them from accurately evaluating their own abilities. As a result, they will persist in making the same mistakes.

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Mike McLaughlin is an economist who makes quarterly forecasts for the state of the economy and interest rates. Last quarter, the economy did not grow as fast as McLaughlin predicted. McLaughlin explains that his forecast was inaccurate by stating This change in the economy was due to a real estate market that slowed faster than many forecasters, including myself, expected. If it werent for the real estate market, my projection for GDP would have been accurate. Which of the following is the best interpretation of McLaughlins statement, from a behavioral finance view? McLaughlin is using:

A) an if-only defense for his inaccurate forecasts and this will prevent him from accurately evaluating his own abilities.

B) a single predictor defense for his inaccurate forecasts and this will prevent him from accurately evaluating his own abilities.

C) a single predictor defense for his inaccurate forecasts and his recognition of it will sharpen his abilities.

D) an if-only defense for his inaccurate forecasts and his recognition of it will sharpen his abilities.

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Answer and Explanation

McLaughlin is using an if-only defense for his inaccurate forecasts. According to behavioral finance, investors will use excuses to justify their inaccurate forecasts. These excuses will prevent them from accurately evaluating their own abilities. As a result, they will persist in making the same mistakes.