A Brief Reminder of How Fast Things Change

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If there's one lesson of the past decade, it's that things change -- fast.

A good example: Read what President Bill Clinton had to say in the 2000 State of the Union address:  

We are fortunate to be alive at this moment in history. Never before has our nation enjoyed, at once, so much prosperity and social progress with so little internal crisis and so few external threats. Never before have we had such a blessed opportunity -- and, therefore, such a profound obligation -- to build the more perfect union of our founders' dreams.

We begin the new century with over 20 million new jobs; the fastest economic growth in more than 30 years; the lowest unemployment rates in 30 years; the lowest poverty rates in 20 years; the lowest African-American and Hispanic unemployment rates on record; the first back-to-back budget surpluses in 42 years. And next month, America will achieve the longest period of economic growth in our entire history.

We have built a new economy. And our economic revolution has been matched by a revival of the American spirit: crime down by 20%, to its lowest level in 25 years; teen births down seven years in a row; adoptions up by 30%; welfare rolls cut in half to their lowest levels in 30 years.

My fellow Americans, the state of our union is the strongest it has ever been.

And then compare it to President Barack Obama's remarks during the 2010 State of the Union:

One year ago, I took office amid two wars, an economy rocked by a severe recession, a financial system on the verge of collapse, and a government deeply in debt. Experts from across the political spectrum warned that if we did not act, we might face a second depression. ... One in 10 Americans still cannot find work. Many businesses have shuttered. Home values have declined. Small towns and rural communities have been hit especially hard. And for those who'd already known poverty, life has become that much harder. This recession has also compounded the burdens that America's families have been dealing with for decades -- the burden of working harder and longer for less; of being unable to save enough to retire or help kids with college.

It took just 10 years to go from Brady Bunch to Mad Max. I think that's incredible.

And this lurch in prosperity wasn't a one-off event. As Clinton noted in the 2000 speech, "Eight years ago, it was not so clear to most Americans there would be much to celebrate in the year 2000. Then our nation was gripped by economic distress, social decline, political gridlock. The title of a best-selling book asked: 'America: What Went Wrong?'"

In 1992, things looked awful. In 2000, all we could see was optimism. In 2010, we were staring straight into the abyss. Former Treasury Secretary Larry Summers has a saying: "A good rule of thumb for many things in life holds that things take longer to happen than you think they will, and then happen faster than you thought they could." That seems fitting these days.

What's amazing about the differences among 1992, 2000, and 2010 aren't the forces that caused the shifts -- a technology boom and a housing bust. It's how fast the shifts took place, and how few saw them coming.  

When dealing with anything that requires us to anticipate the future, one of the most troubling things to come to terms with is how poorly hardwired we are to make accurate predictions. As a 2005 Deutsche Bank report noted, "Who could have imagined in 1991 that a decade of stagnation would beset Japan? Who would have forecast in the same year that an impressive rebound of the U.S. economy was to follow? Simply extrapolating the past cannot provide reliable forecasts."

Yet it's what most of us do. In 2005, the investment bank Dresdner Kleinwort wrote a paper on the history of financial forecasts, and found a startling pattern. When a composite of expert forecasts on things like bond yields and stock prices were overlaid with what actually happened, the forecasts had an almost perfect lag. A few months after bond yields rose, analysts broadly forecast that they would keep rising. A few months after yields fell, analysts switched their forecasts and predicted that yields would continue to fall. Viewed in a chart, it was unmistakable: When forecasting the future, analysts were simply looking at what happened in the past and drawing a straight line. "Analysts are terribly good at telling us what has just happened but of little use in telling us what is going to happen in the future," the report wrote.

So what should you do about it? How do you deal with the unpleasant fact that most of us -- including me, and likely including you -- are terrible at predicting the future? I think there are three things to keep in mind.

1. Think long and hard about the risks you're taking
In 1998, a group of "genius" financiers at a hedge fund called Long Term Capital Management, stacked with Ph.D.s and Nobel laureates, lost nearly every penny they had. At one time, these managers had extraordinary personal fortunes. By taking even more extraordinary risks, they went flat broke.

Warren Buffett later made a wonderful comment about the ordeal:

To make money they didn't have and didn't need, they risked what they did have and did need. And that's foolish. It is just plain foolish. If you risk something that is important to you for something that is unimportant to you, it just does not make any sense.

Average folks do this, too, and a lot has to do with being overconfident that the future will look like the past. I knew a guy who already had a good retirement nest egg built up. He could have lived comfortably off it, yet he blew most of it in a feverish attempt to make more by buying up "investment" homes in Orange County, Calif., in 2005. He's now back at work.

When we think about our investments, there's often too much emphasis on potential gains and not enough on potential losses. In his book The Behavior Gap, financial advisor Carl Richards lays out three questions you should ask yourself before making a big financial decision:

  • If I make this change and I am right, what impact will it have on my life?
  • What impact will it have if I'm wrong?
  • Have I been wrong before?

Most of us could do better by asking ourselves these questions. It's a smart way to think about risk. And as Richards writes, "Risk is what's left over when you think you've thought of everything else. Our assumptions about the future are almost always wrong. We can never think of everything -- but we can take sensible steps to protect ourselves from life's inevitable surprises."

2. Whatever you're feeling, stop and think the opposite
It's impossible to predict the future, but you can do worse than following a simple rule: Whenever the economy is doing extremely well or extremely poor, there's a good chance that things will soon turn in the opposite direction. After booms come busts, and after busts come booms.

After the Roaring '20s came the Great Depression. Then came the booming 1950s and 1960s. After the miserable 1970s came the thriving 1980s and 1990s. Next came the hellacious 2000s. Boom, bust. One after another.

It always works this way. Recessions plant the seeds of recoveries, and booms plant the seeds of recessions. It's counterintuitive, but the absolute best time in modern history to invest was in the midst of the Great Depression in 1933, and the absolute worst time was in 2000, when the future never looked so bright. How many investors foresaw these outcomes at the time? Almost none.

Assuming a State of the Union address is reflective of the mood of the economy, those who think the future is more important than the past should want more speeches like Obama gave in 2010, and should fear those like Clinton gave in 2000.

3. Stop trying to predict what's next
According to Standard & Poor's, two-thirds of actively managed stock funds have underperformed the S&P 500 over the last three years. About the same portion have failed over 10-, 15-, and 20-year periods. According to author Simon Lack, if all the money ever invested in hedge funds had instead been invested in Treasury bonds, the results would have been twice as good.

Think about that. How many man hours have fund managers put into researching, calculating, and prognosticating the future, all for nothing? How many brilliant MIT grads worked until 3 a.m. building forecasting models that turned out to be totally wrong? What if these people had instead just gone to the beach? Or worked at something more productive?

The best way to deal with uncertainty about the future is to accept it. You don't know what's going to happen next. So what? You don't need to. Set yourself up so that you'll do OK regardless of what happens. Save your money. Diversify. Avoid debt. Be ready to adapt. Know that anything can happen at any time.

This is boring, but it offers the best chance at beating the masses who have fooled themselves into believing they're smarter than they really are -- those who haven't learned that things change, fast. As Lao Tzu put it, "Those who have knowledge don't predict. Those who predict don't have knowledge." Smart advice.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

At the time this article was published Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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