“Overestimating what you’re capable of knowing or doing can be extremely dangerous—in brain surgery, transocean racing or investing. Acknowledging the boundaries of what you can know—and working within those limits rather than venturing beyond—can give you a great advantage.”
The hazard if forecasting is the focus of chapter 14 of Howard Marks (Trades, Portfolio)’ book, “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor.”
As investors know, almost every decision we make involves an unknowable future. Marks, though, did offer potential exceptions:
- If we focus on smaller-picture factors, we may gain a knowledge advantage. For example, we can know the fundamentals, but we are still stumbling in the dark about macro issues such as economic conditions.
- Assessing where we are within the context of cycles and swings of the pendulum. This provides a bigger-picture understanding of where we are, but does not tell us what will happen in the near term.
The author did an assessment of forecasting and found it mostly wanting. In general, he found forecasts lacked accuracy; in other words, most were well off the mark once the outcomes were known. For example, when he looked at predictions for the 90-day rate for Treasury bills, 30-year bonds and the yen-dollar exchange rate, he saw forecasters missed the mark by an average of 15%.
Marks also asked if the forecasts were useful; that is, would they make investors any money? Based on polls conducted by The Wall Street Journal, he concluded they would not. Most forecasters “completely missed several major changes” and, therefore, were of no help.
Further examination involved looking at the sources of the forecasts. It turned out most were simply extrapolations of current conditions. The average forecast was within five percentage points of the levels in place at the time the projections were made.
Some of the forecasters were right, at least some of the time. In each Journal poll, someone was within 20 basis points even though significant changes had occurred. Compare that 20 basis points with consensus forecasts, which missed by 70 to 130 points.
So some forecasters were accurate, but they could not consistently be accurate, leading to the assumption they were lucky rather than smart. Those who won one contest did not make accurate predictions in other contests. And in the contests they did not win, they were even less accurate than the consensus.
As Marks pointed out, “It doesn’t do any good to possess a survey of sixty-four forecasts that includes a few that are accurate; you have to know which ones they are. And if the accurate forecasts each six months are made by different economists, it’s hard to believe there’s much value in the collective forecasts.”
That presents an investing dilemma: Results depend on what happens in the future. We may be able to predict what will happen when future events are normal. But we cannot know what will happen when the economic environment is not normal, and that’s when it really counts.
Marks summed up with nine forecasting issues:
- Predictions about the future mostly look like the recent past.
- That’s not necessarily bad, since the future often repeats the recent past.
- Based on these two points, many forecasts will turn out to be right because no significant change occurs during the period of the forecast.
- However, the forecasts listed above have limited value. Marks wrote, “Thus if the future turns out to be like the past, it’s unlikely big money will be made, even by those who foresaw correctly that it would.”
- Sometimes the future breaks radically with the past, even the recent past.
- When this happens, forecasts would be very helpful.
- However, forecasts are least likely to be accurate in such situations.
- Some forecasters will get each break with the past right, however, it is unlikely to be the same forecaster each time.
- Overall, then, “forecasts are of very little value.”
Ask yourself, as Marks did, whether the people who correctly anticipated the meltdown in 2007-08 also forecast how far the market would rebound in 2009. He explained this by noting how those who were right in calling the collapse already tended to negative views. And, they likely remained negative throughout 2009.
No one person’s forecasts are likely to be right all the time, he wrote, “That’s the trouble with inconsistent forecasters: not that they’re never right, but that the record isn’t positive enough to inspire action on their occasional brainstorms.”
On a related matter, Marks wrote about investors who fail to make a distinction between “probability” and “outcome”:
- They believe they know the shape of the probability distribution.
- They assume the most likely outcome will be what happens.
- They hold that the expected result will be the same as the actual result.
- They ignore the potential of improbable outcomes.
Investors who don’t make these distinctions are likely to make mistakes and have large losses at times. According to Marks, that happened between 2004 and 2007, when investors were overly optimistic about which outcomes were knowable and which were controllable. They also underestimated how much risk they were creating for themselves.
In summay, investors who acknowledge they do not know the future will behave differently than those who believe their forecasts or the forecasts of others. And, “those who feel they don’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes.”
In other words, investors who recognize their limitations will be better prepared for the future, whatever it brings, whether more of the same or a radical break.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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