Will the price of Apple go up next year? Has the market passed its peak?
Every day, investors wrestle with questions like these and unfortunately, they’re simply a waste of time that might be better spent preparing. That opinion came from James Montier, author of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy."
He cited the poet and philosopher Lao Tzu as saying: “Those who have knowledge don’t predict. Those who predict don’t have knowledge.”
Yet, investors are always trying to predict what’s ahead — even serious value investors. Consider discounted cash flow (DVF), in which there is a need to estimate — guess, really — what a particular company’s future growth rate will be. Montier highlights the difficulty:
“Let’s say you invest according to the following process: Forecast the economy, forecast the path of interest rates, forecast the sectors which will do well within that environment, and finally forecast which stocks will do well within that sector.”
There are four variables in that process, any of which could trip up the forecaster. Montier said that if you had to get all four forecasts right, then you had just a 24% chance of being correct. The odds, obviously, are against us in correctly predicting what a company’s DCF will be.
He summed up this section by saying:
“The bottom line from this whistle stop tour of the failure of forecasting is that it would be sheer madness to base an investment process around our seriously flawed ability to divine the future. We would all be better off if we took Keynes’ suggested response when asked about the future, 'We simply do not know.' (The name is a reference to John Maynard Keynes, the British economist, investor and writer)."
Which raises the question, why do we continue to forecast?
On a surface layer, some forecasters, including stock analysts, say they keep making predictions, despite being wrong so often, because clients demand them. Montier wanted a better answer, so he turned to researcher Philip Tetlock who did a comprehensive survey of forecasters, their accuracy and their excuses.
The forecasters had a great deal of faith in their forecasts, despite a record that said otherwise. Tetlock found that experts predicting world political events had an 80% or higher confidence level. Their actual results? They were correct only about 45% of the time. And overall, across all predictions, their accuracy was about the same as those of the proverbial coin tossers: 50%.
Tetlock found that excuses for forecasting failures could be categorized into five types:
- Known as the “if only” defense, forecasters explain they would have been right if some other event had not happened.
- Second is the “ceteris paribus” defense (meaning, "all other things being equal"); something outside the forecaster’s model had taken place, and thus it wasn’t their fault.
- Next, the “I was almost right” defense, which is self-explanatory.
- “It just hasn’t happened yet” is the fourth defense; how often have we heard, “My prediction was correct, but my timing was off”?
- Finally, the “single prediction,” as in, “Don’t judge me on a single forecast.”
Why do we keep using forecasts?
Now that we have found out how forecasters justify their past failures and keep on forecasting, we need to ask, “Why do we use them?”
Montier gave one word to explain our ongoing use of forecasts: anchoring. This is defined by Investopedia as a behavioral bias in which we use a piece of irrelevant information to estimate an unknown value. For instance, it points to a tendency to hold onto securities that have lost value because we have anchored our fair value estimate to the purchase price rather than to fundamental measures.
The author himself asked 600 fund managers to write down the last four digits of their phone numbers, and second, to estimate how many doctors work in London. A majority of fund managers whose telephone numbers were 7,000 or higher estimated there were about 8,000 physicians in the city. Those managers whose phone numbers were 3,000 or lower estimated there to be 4,000 doctors in London -- two completely unrelated sets of data, but they became linked because of anchoring.
“Analysis should be penetrating, not prophetic”
The quotation above, from Benjamin Graham, was used by Montier as he tried to set investors on a better path: Get to know the business, and its intrinsic worth, rather than try to forecast the unknowable.
With that, Montier offered three pieces of practical advice to those trying to overcome their addiction to forecasting.
- Investors who use DCF (discounted cash flow) can reverse the usual process, said Montier. “Why not take the current market price and back out what it implies for future growth?” Next, compare the implied growth rate with a distribution of growth rates that all firms have shown over time. If your stock is at the limits of what other firms have achieved, be wary.
- Bruce Greenwald started with the asset value of a company (the remaining value if it were to go broke) and compared that with valuations in the competitive environment. This gave him an outlook for both future profits and intrinsic value.
- Howard Marks (Trades, Portfolio) stated that while you cannot predict, you can prepare. He said, “In my opinion, the key to dealing with the future lies in knowing where you are, even if you can’t know precisely where you ’re going.”
Montier said Marks’ approach reminded him of Graham’s declaration that you can know if a person is overweight or underweight without knowing that person’s exact weight.
And he wound up the chapter with this statement:
“None of the three approaches goes anywhere near a forecast. Yet each has proven investment merit. Of course, this will be anathema to at least 80 percent of those working in or teaching finance and investment. The idea of investing without pretending you know the future gives you a very different perspective, and once you reject forecasting for the waste of time that it is, you will free up your time to concentrate on the things that really matter. So, when trying to overcome this behavioral pitfall, remember what Keynes said, 'I’d prefer to be approximately right rather than precisely wrong.'”
About James Montier
The author is a member of the asset-allocation team at GMO, the firm founded by Jeremy Grantham (Trades, Portfolio) in 1977. He was previously co-Head of Global Strategy at Société Générale. The author of three books, he is also a Visiting Fellow at the University of Durham and a Fellow of the Royal Society of Arts. The book we are discussing was published in 2010.
This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.
Disclosure: I do not own shares in any company listed and do not expect to buy any in the next 72 hours.
