Market Forecasts Are Useful Tools but Dangerous Guides

Stock market forecasting has proven to be a popular pastime of staid financial institutions and energetic media commentators alike.

Hope endures that certain market mavens will be able to see the signals others miss and guide less worldly and wise investors to the promised land of wealth and financial security.

Yet, if one digs a bit deeper into the business of forecasting, it becomes worryingly clear that confident expert outlooks often proves lacking, both in terms of rigor, and accuracy.

Of seers and suckers

Jason Zweig crystallized the key issue with forecasting succinctly -- and rather cuttingly -- with his personal definition of the practice as a whole:

“The attempt to predict the unknowable by measuring the irrelevant; a task that, in one way or another, employs most people on Wall Street.”

Countless institutional market outlook reports are put together with great care, which are then picked over by professionals and amateurs alike. Unfortunately, for all their production values, tables and data projections, these forecast reports are ultimately rarely better than the best guesses based on what is still very limited information.

So why do people still obsess over these institutional forecasts, despite their obviously dubious merits? Once more, Zweig has a compelling (if distressing) answer:

“Because the human mind hates admitting the truth that the world is largely random and unpredictable, forecasters will always be in demand, regardless of their futility. Wall Street follows what marketing professor J. Scott Armstrong has called the seer-sucker theory: ‘For every seer, there is a sucker.’”

In other words, people dislike the idea that the market is unpredictable, and so cleave to the notion that someone, somewhere, has the answers. Hardly a ringing endorsement.

Fooled by randomness

Foecasting’s already dubious reputation takes another hit when we turn to financial media, Yet, as Philip Tetlock and Dan Gardner have pointed out, much of the “superior forecasting power” pushed by market pundits is anything but:

“Watch business news on television, where talking heads are often introduced with a reference to one of their dramatic forecasting successes ...The point is to make them credible so we’ll want to hear their next forecast. But even if we assume these statements are true accounts of what the person forecast -- they often are not -- they tell us next to nothing about the guest’s accuracy.”

The fundamental fallacy of such portrayals is twofold. First, accurate forecasts are often given great attention, while inaccurate predictions fall by the wayside. Second, accuracy is simply not the same thing as consistency; one might be accurate about predicting a recession if one predicts one every year, but such activity obviously lacks explanatory power.

Despite all empirical evidence to the contrary, the financial media continues to portray its roster of popular prognosticators as dispensers of special knowledge and insight. That is not so distressing in itself, but the fact that so many people continue to give these sources of advice genuine credence very much is.

Signs point to somewhere

Nicholas Nassim Taleb, a highly respected statistician, experienced remarkable success operating in financial markets by playing situations in which long-tail risk was inaccurately priced. His insights led to his writing The Black Swan, which details how such mispricing can lead inevitably to catastrophic outcomes, despite those outcomes being ostensibly low probability events.

Unsurprisingly, Taleb’s experiences have led him to take a rather dim view of forecasting:

"There are those people who produce forecasts uncritically. When asked why they forecast, they answer, ‘Well, that’s what we’re paid to do here.’ My suggestion: get another job."

With the stock market testing all-time highs, even as choppy economic data throws up warning signs and the Federal Reserve toys with the idea of cutting interest rates still further, one might think that forecasters would take a step back from the fray. Unfortunately, for many market players and commentators, it is the core of their jobs.

Verdict

Investors should think very carefully before putting their faith in forecasts. Whether they come from institutional investment firms or financial pundits is often immaterial. All too often, they lack any predictive power. As a consequence, unsophisticated investors may find themselves acting on often questionable advice.

Forecasts are far from worthless. They provide a feedback mechanism between markets, consumers and government, while also presenting useful data that can be analyzed independently. However, it is critical that investors treat forecasts -- from whatever source -- as tools to be used to hone their own decisions, not maps to guide their actions. The former course can genuinely improve one’s performance, while the latter strategy is almost guaranteed to end in tears.

Disclosure: No positions.

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