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Abu Dhabi, UAESaturday 22 September 2018

10 reasons why investment forecasting stinks

Even though financial predictions are almost useless, pundits persist in making them and investors in listening to them

The writer believes all financial forecasts are folly. Johannes Eisele / AFP
The writer believes all financial forecasts are folly. Johannes Eisele / AFP

I recently pointed out an errant recession forecast made a year ago by a person who has been more or less been predicting an economic slump since 2011. My intention was to spark a discussion of why forecasts are so counterproductive, and why no one should make investments based on them. Instead, a discussion of passive bulls mocking active bears broke out. This was not what I intended.

I have been harping on about this for more a decade and figured, by now, everyone surely understands that market forecasts - indeed almost all forecasts - are folly.

Alas, my assumption was proven wrong. Thus, we go once more unto the breach, to remind everyone what we know about forecasts and predictions, and why they are so rarely right:

1. Not everything is a forecast

This is especially true in terms of markets and the economy, and so a reasonable definition of a forecast is as follows: It pertains to a specific asset or asset class and/or economic data series, at a given price or level and a specific time. It also must be disprovable. Making a statement that cannot be proven or disproven is not a forecast; it’s a theoretical academic debate.

Consider the following statements: “Stocks tend to go higher” or that “recessions are cyclical.” These are not forecasts because they lack specifics. The statement: “The Dow will hit 25,000 by the second quarter of 2018,” on the other hand, has all the elements of a forecast and it will either be proven right or wrong.

2. We are very bad at forecasting

Examples are everywhere: economic forecasts, earnings estimates, market forecasts and expectations of future technologies, not to mention election predictions. The data overwhelmingly show that as a species, we are simply awful at this.

3. We are even worse at predicting our own behaviour

I have been highly critical of those surveys that ask people to describe what they plan to do in the future. Whenever you see someone forecasting their own behavior, what you are getting is a read of their emotional state. Whether it's holiday shopping, company hiring plans, voting intentions - people say what they are feeling at the time the question is posed, and it is not predictive of what they are actually going to do.

4. Random and unforeseeable events ruin forecasts

Try going back and looking at the record of forecasts made years or decades ago. Most of them are inaccurate for the simple reason that they were overtaken by random or unforeseeable events.

5. Technology is tricky

We are particularly bad at making predictions about technology. This goes back a long way, to claims in the late 19th century that no one would ever need or want a telephone, or that cars would never replace horses and buggies. And folks are still at it, despite their inability to get it right. Check Microsoft chief Steve Ballmer's 2007 prediction that Apple iPhone would never catch on.

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6. Forecasts are marketing

If forecasts are so useless, why are they so prevalent? I don’t know of a clearer way to say this: A forecast is usually accompanied - directly or otherwise - by an effort to sell something. Predictions are inherent in marketing campaigns. It's as simple as that.

7. Random luck

People tend to over focus on the outcome rather than paying closer attention to the process. This leads to an overemphasis on guesses that were merely lucky and therefore cannot be replicated.

8. Asymmetric risk

Bad forecasts are quickly forgotten, while those who make accurate predictions that are nothing more than the result of luck or random chance get elevated to stardom. This is the entire underpinning of why people make forecasts - and especially radical scary ones - in the first place. The potential rewards for being right can be significant, while being wrong has little downside.

9. Failing to acknowledge a mistake

Many people engage in the sort of ego-driven decision-making that leads to bad outcomes. Rather than admit error, they prefer to stay invested based on their predictions rather than do what's best as an investing strategy. Renowned technician Ned Davis literally wrote the book on this and the title says it all: Being Right or Making Money.

10. Making better predictions

There is some hope for improvement in forecasting: Phillip Tetlock, author of Superforecasting: The Art and Science of Prediction, explored how forecasters can use data and logic to improve the probabilities of reaching a desired outcome. Note the word "probability" instead of prediction.

Now, if only investors would pay heed.

Barry Ritholtz is a columnist for Bloomberg

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