One of the most common sayings in our industry is that, "There is no crystal ball." By saying this, everyone acknowledges that we are not fortune tellers and cannot predict the future. The ironic thing though is that after we say it, most advisors go on to TRY and predict the future in their advice to clients. It kind of begs the question, why do we bother saying that we have no crystal ball in the first place?
Well forecasting (the more socially acceptable term for predicting the future) is a major part of all investing. By necessity when you are making an investment, you are making a prediction on the future. At the very least you are predicting that, there will be no major geopolitical or environmental catastrophes, the financial system will continue to function as it normally does, you will live long enough to take advantage of your investment, and the investment you've selected, regardless of what it is, will perform within a range of your expectations. These are all forecasts. Some of them are much more likely than others.
If I forecast that the sun will rise tomorrow, I've got a pretty good chance of being proven right on that. On the other hand, the people who tried to predict the winner of the 2016 Presidential election – well let's just say there was a lot of surprised forecasters.
In the financial industry, the amount of predictions made is rivalled only by the amount of failed predictions. If you take a given stock which is covered by analysts, the level of mistakes is staggering. There is only about a 1 in 132 chance that the analysts' consensus forecasts will be accurate (within 5%) for four straight quarters. That means that if you're predicting the earnings of a company a year out, you have about a 1 in 132 chance of being right. If you go out 5 years, the odds rise to 1 in 40 Billion. In other words, it is borderline impossible.
Human beings today, with our available technology and intelligence are simply not capable of making predictions to this level of accuracy. So why do we keep trying? And why do we rely so much on expert forecasts?
Well if we look at some of the most well-known forecasters, they are all very talented at one thing. Unfortunately, that one thing is not forecasting. It is storytelling. The most well-known expert forecasters are great storytellers. They are salesman, who are selling you a vision of the future. The more compelling the salesperson, the more likely you are to buy their forecast. It won't help you predict the future, but it is nice work for the forecaster.
Believe it or not, there are people who are demonstrably better at forecasting the future than most. However, they are not what you might expect. They aren't the highly paid analysts on TV or even highly trained and well-resourced people who work for the CIA or in the White House. In the book Superforecasting By Philip Tetlock and Dan Gardner, they detail some superforecasters drawn from ordinary people that you would find in your own neighbourhood. They are all smart though not necessarily exceptionally so. They don't have the vast resources of a Wall Street bank or the years of training of a CIA analyst. Nevertheless, they still manage to be better forecasters.
Forecasting like anything is a skill, and it requires a certain skillset. The good news is that the skill scan be learned. Even you can learn to be a better forecaster. Now in order to become a really good forecaster will take practice and will also take study. I can't give you all of the information in this article about what you would need to know. However, one thing I can do is to highlight a few concepts where the superforecasters get it right, and the so-called 'experts' often get it wrong. If you pay attention to these factors, you won't be able to become a better forecaster yourself, but at least you'll be able to better spot the bad forecasters.
One thing to recognize about forecasting is that there are limits to what we can forecast. Forecasts which are overly detailed and precise are more likely to be wrong. It is better to be generally right than specifically wrong when making a forecast. An example would be: "It is going to rain this afternoon," would be generally correct, but the more specific prediction of "it's going to rain 19 millimeters this afternoon," would be specifically wrong. It is much more difficult to make the latter prediction so therefore anyone relying on that forecast is going to be much more likely to be disappointed.
This also works for a company. You can generally predict that a company earnings are likely to grow. If you invest based on this general forecast, you stand a much better chance of being right. However, if your investment was relying on the forecast that "this company is going to grow at 15.7% a year for the next 5 years," then that is a much more specific forecast which, as we've already seen is almost guaranteed to be inaccurate.
Another limit on forecasting is the timing of it. For many things it is much easier to predict something in the near term than in the long term. We usually accept the weatherman's forecast for tomorrow but are far more skeptical of their forecast for a month from now. This is no coincidence. Meteorologists are pretty accurate over the shorter time period, but the complexity of weather patterns makes it almost impossible to predict with accuracy that far out.
The same is true for predicting things like international relations or the movement of the stock market. We need to be careful with this one though. Over the short term it is easier to make certain predictions, but not all predictions. For example, I have no idea if the S&P 500 index will go up or down on a given day. However, over the longer period of say ten years, I am much more likely to be proven correct if I predict that the index will rise over that period. The reason why this is more likely to be correct is that the unpredictability of human behavior tends to be less important over the longer term, whereas in the short term, the stock market is driven almost entirely by unpredictable human behavior.
In order to be a superforecaster you need to be aware of what you don't know. You also need to improve when you make mistakes, and that first requires you to recognize that you made a mistake. This humility also has a positive side effect when it comes to investing, because a humble superforecaster will build in a sufficient margin for error. This margin of error could also be called your margin of safety. A margin of safety allows for a positive result even in situations where the actual results are much worse than your forecast.
This is a key element in good investing. It is right to be skeptical of forecasters. Many of the ones we see as the 'experts' are no better at forecasting then the proverbial chimpanzee throwing darts. In addition, there are always going to be unpredictable events that happen which can alter dramatically the course of the future. However, this doesn't mean that forecasting is useless in all circumstances. There are some things we can forecast, and in many situations, we rely on these forecasts to be successful, especially with investing.
Hopefully by noticing the characteristics of a good forecast, and a good forecaster, you will be better prepared to spot them in the future.
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at the award-winning firm Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
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