Let’s face it, the ability to peer around the corner and forecast the future (tomorrow, much less next month) is one of the biggest challenges for global business executives. If you have made forecasting mistakes in the past, take heart, you’re not alone. You can however, learn to forecast a bit better by avoiding a common mistake–anchoring.

The concept of anchoring in decision making was made famous by psychologists Daniel Kahneman and Amos Tversky. In a well known experiment, they asked a group of people to estimate the percentage of African countries in the United Nations.

Before each person guessed, they were asked to spin a wheel with the numbers 0 to 100 clearly labeled. According to a Money magazine article, “When the wheel landed on a low number, people tended to guess that African nations made up a small percentage of UN members; when it landed on a high number, they guessed that Africa accounted for much more of the UN’s membership.”

A recent Wall Street Journal article also highlights the problems of anchoring. The article mentions that in December 2008, Barron’s asked a dozen experts to forecast the level of the Standard and Poor’s 500 stock index at the end of 2009.
Despite a tumultuous 2008, where the stock market would regularly jump 500 points in a single day, not one expert predicted a down year for 2009. And while 2009 still has yet to play out, each of the twelve experts predicted a 5-38% increase with a median of 13%!

The author of the WSJ article, Jason Zweig, believes the stock picking experts are guilty of anchoring. He says we tend to over-extrapolate in forecasting when we base our decisions mostly on what happened in the past. Zweig writes, “(With) the fat five years from 2003-2007, when stocks shot up by an annual average of 12.8%, who expected 2008 to be a bloodbath?”

Who indeed? With the exception of Nouriel Roubini and a few others, most market prognosticators missed the mark.

In fact, accurate forecasting can be hard–or easy. Let me explain.

Years ago, as a divisional manager for a regional telecommunications firm, I was responsible for presenting my annual division revenue forecasts to the company president. These forecasts were very important, as staffing decisions and budgets would be initially based on the “acceptance” of the forecasts.

When visiting the office of another divisional manager, I was shocked to find out he was finished with his forecasting processes–in record time. He finished quickly by taking last year’s revenue numbers and adding 10%! Adding insult to injury, his last year plus ten percent forecasts were accepted by the company president!

Alas, the above story would be much richer if my colleague’s exercise in anchoring ultimately cost him dearly. He was lucky–in this instance his predictions came pretty close to reality. His gut decisioning (or perhaps laziness) came through for him.

However as levels of volatility and systemic failures increase in marketplaces and economies, and wild swings become the norm–anchoring and basing forecasts on what happened last year can ultimately lead to disaster. Need proof? Just query the terms, “investment bank” or “hedge fund” in the search field of the online Wall Street Journal.

To avoid anchoring in decision making, carefully consider assumptions and take no probability off the table. Think about your “reference point” for making a decision and then consider reasons why this particular point is your anchor. Does it take into account the possibility of an extreme outcome?

If you think it couldn’t happen–pay special attention to that scenario. It’s pretty wild out there–anything is possible!
Questions for DailyFix readers:

* In a tough economic environment, the penalty for poor forecasting increases. What tools and methods are you using to anticipate events and predict the future?
* Author Peter Bernstein says, “The successful businessperson is a forecaster first–all other activities follow.” Do you agree with this statement?
* What “experts” via news, commentary, consulting etc, are helping to guide your decisions on the future? Are these experts getting more or less reliable?
* What is the one event–if it happens in 2009–that will shake up the game board and change all the rules? Is this event on your radar screen?

By now you’ve likely heard of Bernard L. Madoff. This hedge fund operator is accused of the largest corporate fraud in United States history, to the tune of $50 billion dollars lost. In a SEC complaint, Mr. Madoff–a former NASDAQ chairman–is accused of a “stunning fraud of epic proportions” by essentially running a Ponzi scheme where new investor money was used to cover losses and pay-out returns to previous investors.

While there were plenty of warning signs along the way such as steady returns during tumultuous times and allegations of manipulation from other brokers, investors continued to pour money into Madoff’s funds.

Madoff used interesting schemes to dupe high net worth investors, many of which preyed on basic human needs of social connection and esteem.

According to a Wall Street Journal article, Madoff cloaked his investments in a “mysterious allure and sense of exclusivity.” Simply getting into the club–if you will–gave investors bragging rights, a sense of belonging, and enabled them to feel they had access to something special.

In fact, according to the same WSJ article, once an investor was “in”, it would be considered an insult to ask deep questions about the fund for fear of being thrown out. “When you are in an exclusive private club,” the article notes, “you don’t go rummaging around the kitchen to make sure the health code is being followed.”

Adding insult to injury, many of Madoff’s customers came from good old “word of mouth” connections where new clients were referred by other wealthy families, political leaders, and charity organizers.

Mark Penn, writes in a recent Wall Street Journal article, that Madoff, “sold himself to people on the basis of brand, and he got access to more marks by using the smart, rich and famous to introduce him to more of the smart, rich and famous.”

Madoff’s fund wasn’t built on advertising. It wasn’t built on direct marketing tactics. It was built on leveraging customer trust, exclusivity, and word of mouth recommendations.

Many otherwise very intelligent people failed to ask questions of Mr. Madoff as they invested millions of hard earned dollars.
While red flags popped up on occasion, as long as “the returns” kept coming most investors operated from a “don’t ask, don’t tell” perspective. Investors, referred by other people they trusted, wanted to gain access to this exclusive hedge fund so badly that they in effect checked their brain at the door.

Don Peppers and Martha Rogers often talk the importance of building customer trust to improve revenues and profitability. In an article, “Trust Stakes Its Claim“, they say, “Although trust is the welcome consequence of any successful customer relationship, it is not something to take for granted. Building trust is an investment in the future of your customers. You have no more important asset; you have no more important strategy.”

While many companies have altruistic motives for building customer trust, Madoff did the opposite–using customer trust to defraud. He leveraged his political, social and faith (Judaism) network to ensure a steady flow of recommendations (and investors). And people blindly trusted him with their millions.

Surely, this is an egregious example of fraud, and hopefully an outlier. That said, as economic times get tougher and scam artists abound, it is probably fair to ask more questions, perform due diligence on personal and corporate investments, and check the assumptions that underpin our decision making.

Should we stop trusting altogether? That’s not a very practical strategy. We live in communities, we need to participate. That said when it comes to recommendations– whatever their source–we should at least pause and think about the motivations for those recommendations. Opaque is out, transparency is in.

Questions:
* Should recommendations–from companies, friends, relatives, etc be trusted? Under what circumstances?
* Many of Madoff’s investors were “swayed by the gut” and ignored the warning signs. What analytical techniques could have sniffed out this fraud?
* With cases of fraud and deception abounding, what practices can companies use to establish and maintain customer trust?
* Have you taken a break from thinking in a significant area of your personal life or business? Who is watching your hen house?