I have long been fascinated by our need to make predictions and forecast of future events. This seems especially inconsistent given the fact that we know the future is uncertain. Yet we are drawn to it like some false temptation. I realize most will quickly point out that in order to successfully invest we must have some foresight to where things might be heading- whether it’s the stock prices, the price of gold or economic statistics. I simply disagree with this notion. Yes, there have been a select group of market gurus who have made accurate prognostications. However, the forecasts are usually vague, dependent on luck and give little indication as to when the events will happen (remember a broken clock is right twice a day). In fact, I believe it’s entirely possible that any attempts at prediction may often be more harmful then none at all. We will discuss why later in the discussion.
I recently came across an article entitled “How to predict the Stock Market”. I’m never really interested what the predictions are, but rather why they are made in the first place. This particular author lays out a two step approach for forecasting the stock market. It involves arriving at earnings estimates and choosing a multiple on those estimates. I’ve highlighted the last sentence from the article because it seems puzzling to say the least. Here is a brief excerpt;
“The first step in predicting how the stock market will do for the year is to come up with an earnings estimate for all the companies that make up the S&P 500. Basically, you have to predict how much money you think all these companies will earn in 2010.
The problem is that analyst estimates are often wrong, particularly during periods of economic volatility. Think about it, to predict how much money just one company will earn for the year requires you to estimate hundreds of variables, and then try to account for things you have no control over, like the housing market, commodity prices, inflation, interest rates, tax rates, terrorism, and political instability, just to name a few. Then different analysts come up with different estimates, which also complicate things. But hey, if you want to predict the stock market, you’ve got to eventually settle on the earnings estimates you want to use.”
It seems the author lays out a case for why one attempt to make any forecasts – very confusing.
The future, like any complex problem, has far too many variables to be predicted. Quantitative models historical models have all been tried and most if not all have failed. Predicting the stock market has been compared to attempting to predict moves within a chess game. This would be much easier because there is a finite set of moves possible. There are an overwhelming 10 to the 120th power possible moves. That's a 1 followed by 120 zeros! This is a number far too great to wrap our head around.
The best prediction machines known to us are actually our own brains. Many people think of the brain as either a really powerful computer, but it turns out that the brain is not mysterious, nor is it a computer; rather it can quickly observe a set of variables and make educated guesses. That is one of the reasons we do well at games like chess or baseball. While a human brain cannot calculate a mathematical equation for the trajectory of a ball in mid-flight as a computer would do, we are still capable of determining where the ball will land and making the catch.
Nassim Taleb makes a very compelling argument against forecasting in his books. He explains that we can make use of very short-term guesses or predictions, but long-term forecasts are nothing more than pure guesswork. We are guilty of ascribing far too much predictability to the truly unpredictable. It is very common for our human brains to believe we are recognizing patterns which are only a random sequence of events. Experts have tried to overcome our human fallacies with tools such as quantitative modeling. However, even these models play only on our biases. We believe that models that have accurately predicted the future in the past are likely to predict the future going forward. But that is no more true than believing me when I tell you that a coin will land heads up just because I accurately predicted it would do so the last ten times.
Predictions that were once considered accurate beyond debate may still fail to materialize. It wasn’t long ago that many educated prognosticators forecast a steady rise in home prices – forever! How could one argue – it had been true ever since the data had been recorded. Many smart investors made very bad bets relying on this type of forecast. But even if we could draw meaningful conclusions, how do we actually profit from this information.
I mentioned earlier that attempts to forecast may actually prove harmful to our investment success. Most of the problem arises when our human brains tend to weigh recent events much more heavily than longer term indicators. Of course, as recent events have confirmed all too well, the past really isn't a good indicator of the future. This can lead to serious bias flaws in our decision making process.
It is true that our brains are good at making educated guesses, but don’t confuse this with forecasting. Differentiating from a prediction and making an educated guess based on factual data is an important consideration. As previously discussed, we can draw conclusions about broad demographic trends such as the aging population with some degree of accuracy. This information can guide us as one small part of the process. But it should by no means be our only process. As to why we attempt to predict the future? Perhaps it’s our human need to believe we are in control in a very uncertain world.
