26May 2016

Bertie Thomson

Senior Investment Manager, European Equities

Don’t be a turkey: the perils of forecasting

Humanity has been aware of the dangers of predicting the future for millennia, yet many today still believe in the sagely words of crystal ball gazers. Investors continue to pour over economic forecasts and investment recommendations to inform important financial decisions. We explain why they may be wasting their time and argue that a long-term, bottom-up approach to investing is the best way to profit from financial markets.

For many years, economists, strategists and the investment advisors have made predictions on a wide spectrum of different variables including GDP growth rates, currency rates, the oil price, earnings and so on. Such forecasting is common, but it is also highlights the human trait of extrapolating current trends into the future in a linear fashion. The problem is that we know the world doesn't work in a linear fashion, largely due to human nature. It is investors’ demand for certainty that compels economists, stockbrokers and others to produce forecasts and reasoning that very often turn out to be incorrect.

Nassim Taleb tells an interesting anecdote in his book ‘Black Swan’ that neatly summarises the challenges in forecasting the future. Taleb describes a turkey that is fed every day by a ‘friendly’ butcher. "Every single feeding will firm up the bird's belief that it is the general rule of life to be fed every day by friendly members of the human race 'looking out for its best interests,' as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief…”

The inherent difficulties of forecasting the future are well known. Renowned equity investor Philip Fisher, for example, warned of making precise forecasts and overly relying on them: “I believe that the economics which deal with forecasting business trends may be considered to be about as far along as was the science of chemistry during the days of alchemy in the Middle Ages”.

We are incorrect in the way we approach forecasting, particularly when it’s applied to the wider macro-economic environment and the markets whose fortunes ebb and flow with it. Given all the well-documented wisdom that the future is unknowable, why do we give precise economic and financial forecasts such close attention?

Much of this comes down to the way that our minds work. Psychologists Daniel Kahneman and Amos Tversky have classified how our minds work into two “systems” – System 1 and System 2. System 1 operates automatically and quickly, like when you have a gut feeling about something. System 2 allocates attention to mental activities requiring effort. There is only a range of outcomes that our minds can entertain even when we stretch System 2 to its limits.

We like to think that the world is going to evolve in a linear fashion and once we have picked our path we are mentally committed to our view of the future. We have made our bet and want to believe that the future will play out as we expect. Not having a clear view of the future and replacing it with a range of unknowable outcomes can be quite uncomfortable. Furthermore, thinking through every permutation would be mentally exhausting so it is easier and more comforting to stick with one view.

Amusingly, Taleb has a name for the practitioners that make economic systems more dangerous by reinforcing a particular ‘knowable’ and ‘certain’ view of the future. He calls them ‘fragilistas’ – ‘someone who causes fragility because he thinks he understands what’s going on’. It is very easy for us to huddle around Fragilistas due to their supposed superior ability to predict the future and informational cascades soon develop. Particularly pernicious is hindsight bias – the tendency to be overconfident before an event and then to state ‘it’s so obvious and entirely predictable’ after the event. Predictions from those with no personal stake in the matter are also something to be wary of.

One of the most obvious recent examples of our faith in the unpredictable relates to the oil price. At the beginning of 2014, most investors and market participants were convinced that the oil price wouldn’t fall below USD 80 per barrel. The CFO of one supermajor oil company told us that he thought the raw economics of supply and demand should result in a USD 80-90 per barrel price range with higher prices due to geopolitical risk’. A large aerospace company we visited in November 2014 believed high oil prices were “here for the long term”. Such overconfidence reminds me of Taleb’s turkey – we all know what has happened to the oil price since then.

In light of this, how should investors approach financial markets given that the future is unknowable? Perhaps the most important rule is to invest for the long-term. Markets may be volatile and uncertain in the short-term but over longer periods, fundamental factors come to the fore. Inherent in this approach is buying securities or funds on a bottom-up basis, rather than on a top-down forecast of economic variables. This works because there are less variables and therefore less potential forecast errors. Invest in securities or funds with unique offerings that offer strong growth potential, which can grow regardless of the external environment.

Just as important is to ensure your portfolio is sufficiently diversified. Funds with genuine diversification rely less heavily on manager skill to drive returns and therefore tend to deliver a more consistent outcome. Although genuine diversification can be difficult to substantiate, managers that allocate to a large number of asset classes are able to select assets that have attractive return characteristics yet different return drivers. This means they should experience smaller drawdowns during times of stress.

By focusing on sustainable growth, valuation upside and diversification, we aim to insulate our investors against the unpredictable.

Bertie Thomson, Senior Investment Manager, European Equities

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