Harry believes gold prices will go up. In fact, he believes it so strongly that he decides to bet his life's savings on that scenario. So, he cashes in his stocks and bonds and invests in gold coins, mining shares and gold futures.
If his forecast comes true and gold prices go up, Harry will make a killing. But what if he's wrong? If gold prices drop, Harry will be up a creek without a paddle. His life's savings will shrink, and he will have missed the opportunity to take advantage of other investments in the interim.
Betting on one guess is called "scenario investing." Scenario investing can produce great profits or great losses. But it can also be a helpful tool -- if you don't end up putting all your eggs in one basket.
Formulating a scenario is a good discipline as long as you keep an open mind. It forces you to think through your assumptions and expectations. But don't forget the "what ifs." Stop and think of what will happen to your investments if your guess is wrong.
What about listening to the professional gurus? Most financial soothsayers are either prophets of boom or prophets of gloom. When was the last time you heard a forecaster say: "I don't know" or "Things are going to stay the same"? These kinds of statements -- the bane of forecasters -- are boring to the press and television, and they don't generate additional business. The followers of these crystal-ball gazers would say, "If there are not going to be any changes, then why change anything?"
And there is another pitfall. Just as leopards don't change their spots, many financial soothsayers don't often change their "sooths." The eternal optimists are always forecasting good times ahead; the doomsayers expect perpetual disaster.
Statistics show that professional forecasters as a group don't do any better than a coin toss -- not because of ignorance but because so many events affecting our world are, in themselves, unpredictable. And, even if an event is predictable, its consequences may not always be. A forecaster may even be right a few times in a row, but that does not guarantee the accuracy of the next call.
Why, then, are soothsayers so popular? There are two main reasons:
* People want to believe that someone has all the answers. The more certain the forecasters sound, the more confidence they inspire. Many people assume that they are experts and, therefore, beyond questioning.
* You only hear about these gurus when they are right (and then you hear them everywhere). But, keep in mind that even a stopped clock shows the correct time twice in every 24 hours.
How can you use scenario investing without getting hurt? You can let a scenario of the future serve as a guide rather than a dictator and try to hedge as many of your bets as you can.
Here are a few ways to reduce your risk:
* Diversify your investments among different asset classes. This should reduce your exposure to any one event. Diversification means a lot more than just buying different stocks. It means keeping some cash (money-market funds), some fixed-income investments (bond funds, certificates of deposit or fixed annuities), some stocks, some real estate and some foreign investments. How much you should put where should be guided by the scenario as well as your own personal needs.
* Monitor your investments for unexpected changes. That way, should your assumptions turn out to be wrong, you will find out in time to do something.
* When the tide turns against you, cut your losses. It may be emotionally painful for most people to sell a "loser" or admit to a mistake, but it's better for the pocketbook in the long run.
Susan Bondy founded her namesake financial services company 1980 to provide financial planning and asset management. She is the author of "How to Make Money Using Other People's Money." Write to Susan Bondy in care of The Sun, 501 N. Calvert St., Baltimore, MD 21278. All letters will be treated confidentially.