You Can't Make Financial Predictions Based on the Past

This article is an excerpt from the Shortform book guide to "The Psychology of Money" by Morgan Housel. Shortform has the world's best summaries and analyses of books you should be reading.

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Do you look to history when trying to make financial decisions? Why is trying to make financial predictions based on past events a terrible idea?

In his book The Psychology of Money, Morgan Housel says that many people will study past events in order to make financial predictions. However, Housel explains, this strategy doesn’t work because history is a series of unpredictable events, and studying it will not help you predict the future of finances.

Here’s why you can’t use the past to make financial predictions.

You Can’t Rely on History to Predict the Future

To create a successful financial strategy, you must predict what the markets will do decades from now. Most people base these financial predictions on past events—but doing this, Housel argues, is one reason so many people fail financially. He contends that you can’t rely on history to predict the future for two main reasons.

#1: History Is a Series of Unpredictable Events, and the Future Will Also Be a Series of Unpredictable Events

Housel argues that events make history precisely because they’re unpredictable: In other words, history is itself a record of unpredictable events. Similarly, the future will also be unpredictable: Just as the past has continuously surprised us, so too will the future continue to surprise us.

He then argues that the biggest events we can’t predict—the outliers—will set off unpredictable chain reactions that will have the biggest impact on our economic futures. But since studying history can’t help you predict the outlier events—or their second- and third-order effects—it’s not as useful as we want it to believe.

To illustrate, Housel describes how the terrorist attacks of September 11, 2001, led to today’s student loan crisis. After the attacks, the Federal Reserve cut interest rates to shore up the wobbling economy that resulted. This worked initially: Americans took advantage of low interest rates and borrowed money. But they took on more than they could afford, which led to a credit bubble that popped in 2007. Thanks to the ensuing recession, people who couldn’t find jobs decided to get a college degree, which Housel argues led to the current crisis where people hold $1.6 trillion dollars of student debt and default 10.8% of the time. As Housel notes, it would be practically impossible to predict the student loan crisis as a result of the September 11 attacks—but that’s exactly what happened, and most of history follows similarly unpredictable patterns.

(Shortform note: One reason predicting the impact of outlier events is so difficult is because so many other factors also influence the events’ impact. As one article points out, had the Federal Reserve limited borrowing, their change in interest rates wouldn’t have driven a credit bubble—so there may never have been a recession that triggered a student loan crisis.)

Why We Keep Using History to Predict the Future

Why do we continue to insist that history can help us predict the future? After all, we’ve been making predictions for thousands of years. So presumably, many people other than Housel have realized by now that it’s impossible to predict the events that make history—or the consequences of the outlier events.

One possibility is that not knowing what will happen in the future terrifies us; and, as we’ll learn in Lesson #18, telling a story about what will—even if it doesn’t come true—comforts us by giving us a sense of control.

Alternatively, we may all suffer from a psychological phenomenon known as the hindsight bias. In Thinking, Fast and Slow, psychologist Daniel Kahneman examines why and how we make decisions, explaining that once we know the outcome, we connect the dots in the past that make the outcome seem inevitable and predictable. In other words, we don’t remember how uncertain we were in the past—once you know what happens, you believe your past self was more certain than you were, which leads you to believe that you’re good at predicting the future. If you think this, you may also mistakenly believe that others are good at predicting the future, too.

#2: Modern Financial Structures Are So Different From Past Financial Structures That Older Advice Often Doesn’t Apply Today

Housel explains that many modern financial concepts have existed for an extremely brief time. For example, the market for cryptocurrency—decentralized, digitized currency—was valued at $1.49 billion in 2020, but cryptocurrency didn’t exist in a popular and usable fashion until 2009. Therefore, gleaning financial advice from what happened in the past is somewhat useless because the economic structures that exist are fundamentally different: Investing advice from 20 years ago doesn’t mention cryptocurrency because it didn’t exist yet. So if you rely too much on economic history to predict what’s going to happen next, you will likely fail and may struggle financially as a result.

(Shortform note: In Fooled by Randomness, Taleb makes a practically identical argument, noting that the difference between modern and past structures makes it difficult to apply lessons learned from past structures to the future. However, Housel focuses on major changes in structure, like options that didn’t exist in the past. Conversely, Taleb points out that the details matter too: The Asian markets of the 1990s bear little resemblance to the ones today due to changes in the world economy, but it’s not because stocks work in some fundamentally different way.)

3 Rules for Following Historical Advice

Just because history isn’t as useful as we want it to be doesn’t mean you should ignore history. Rather, Housel argues, you need to use it carefully. To do so, follow three simple rules.

#1: Note the Date

If you’re looking for specific advice, rely on contemporary history. The more recent, the more likely you are to be living in a similar financial situation. (Shortform note: Housel never specifies what counts as contemporary economic history. Consider researching how old potentially relevant financial structures are, and only review material published after that date.)

#2: Look For Patterns of Behavior

You can look at broader swathes of history, too—but don’t look for specific advice from it. Instead, use it to find broader patterns and takeaways, such as how people react to uncomfortable situations or to attempts to motivate them. For example, look at what people tend to do with their money when their governments are unstable. (Shortform note: This advice is similar to Housel’s recommendation in Lesson #2 to look for patterns—not specifics—when evaluating the role chance plays in individuals’ financial successes. In both areas, Housel’s advice aims to eliminate the risk that you’ll base your decisions on the effects of random events, instead guiding you to base them on more predictable influences.)

#3: Be Open to Pivoting

As evidence of how economic changes affect investing advice, Housel points to Benjamin Graham’s The Intelligent Investor—an enduring investment classic even though its specific recommendations are essentially useless in the modern day. Housel explains that this isn’t a sign of Graham’s lack of investing skill but a sign of Graham’s adaptability and knowledge: Graham wisely updated the techniques in his text five times in a span of 40 years because his previous recommendations didn’t work as well as they used to as the world changed.

(Shortform note: Helpfully, modern editions of The Intelligent Investor don’t require you to differentiate between which principles remain helpful and which recommendations are outdated: The 2003 edition includes commentary from a columnist for the Wall Street Journal that points out how Graham’s advice has been timeless through specific major stock market events.)

By referencing Graham’s adjustments, Housel implies that as you implement the lessons you learned from history, you also must pivot when the situation calls for it. When the world inevitably changes—whether that’s through an unpredictable event or because the government introduces a new economic structure—adjust your strategy accordingly. Don’t blindly follow techniques that worked in the past if they don’t work in your current situation.

(Shortform note: How, exactly, will you know when it’s time to pivot because the situation has changed and the advice you’re following isn’t working? In The Effective Executive, management expert Peter F. Drucker recommends looking at the outcome yourself: If you don’t know what’s actually going on, you can’t evaluate whether what you’re doing is working. In a financial situation, pivot when your strategy is no longer increasing your wealth.)

You Can’t Make Financial Predictions Based on the Past