The failure to forecast

24Oct05

Much of what you read in sell-side investment research and the popular financial press involves the dissemination of various forecasts. Whether it be, earnings estimates, stock price targets or forecasts of a whole range of economic variables, we are awash in predictions. While we occasionally see studies of analysts’ skill at forecasting, by and large most predictions go by with little or no notice when they invariably do not come true. That is except for the occasional guru who correctly predicts a subsequent high profile event, i.e. stock market crash, and continues to harp on it for the rest of their career.

The fact of the matter is that predicting financial and economic events is generally very difficult. Think about the complexity of the global economy and its effect on various outcomes. It is foolhardy to think that the majority of analyst should be able to correctly predict the future.

Art De Vany writes that:

The future is over forecasted and under predicted.

In short, we as humans are poor at predicting the future, but do not hestitate to do so. De Vany points to a piece by James Montier, global equity strategist, at Dredner Kleinwort Wasserstein, that highlights in great detail the Folly of Forecasting. Montier summarizes:

Both an enormous amount of evidence and anecdotal experience suggests that people are very bad at forecasting. This is often because we all tend to be massively overconfident. This begs two questions, firstly why do we persist in forecasting despite the appalling track record? And, more importantly, why do
investors put forecasts at the heart of the investment process?

We highly recommend this piece not only because it exhaustively documents the inability of Wall Street to predict the future, but this conclusion has a logical effect on how one should go about making investment decisions. Forecast-free, portfolio management requires one to use existing data to make decisions. Common strategies that conform to this are value-based strategies, or price-momentum strategies.

Nicholas Taleb has been instrumental in making the wider investment community aware of this human phenomena of forecasting folly. He is the author of the book, Fooled by Randomness an a personal web site of the same name. On the occasion of the paperback release of the book Taleb was interviewed by Amy Stone of BusinessWeek.

Taleb has been criticized for seeing the world as hopelessly random, but he disagrees:

“I’m not saying that everything is random,” he explained in a wide-ranging two-hour interview in a Manhattan coffee shop in mid-October, when he was still smarting from a critical review of his ideas in The New York Times. “But that we often see causality where there may be none.”

We can see that Taleb will come down on the same side of the notion of forecasting. From the BusinessWeek article:

In the same way, argues Taleb, just because an investor has beaten the market for 10 years doesn’t mean he will continue to do so. The same goes for the track records of companies, economic cycles, and almost any financial market. “The past is not predictive of the future,” he says. His mantra is that if something really terrible could happen to financial markets, it probably will at some point, and investors need to be prepared or risk getting wiped out.

We would recommend the BW article as a good starting point for Taleb’s work. One can also head over Taleb’s site to read a book excerpt entitled the Scandal of Prediction that expands on this topic.

Taleb’s investment strategy is decidedly forecast-free, but utilizes an largely option-based strategy to take advantage of rare events that the market is under or overpricing. Each investor needs to devise an investment strategy appropriate to their own personal situation, but the wise ones will not rely on forecasts of the future to guide their portfolios.



2 Responses to “The failure to forecast”


  1. 1 Abnormal Returns » Blog Archive » Forecasting folly follow-up
  2. 2 Abnormal Returns » Blog Archive » Taking advice from the (already) wealthy

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s


%d bloggers like this: