The Forecasting Fallacy

"Those who have knowledge don't predict. Those who predict don't have knowledge", said Lao Tzu back in sixth century, long before stock markets existed. Indeed, if there's just one behavioural investing trap you should aim to eliminate in 2018, it's the tendency to blindly follow forecasts. Forecasting securities markets and their precise, time-bound outcomes is nothing but an exercise in futility.

Time and time again in the past fifteen years, I've witnessed first-hand, just how severely analyst, economist and all other expert forecasts can go outrageously wrong. In 2008, most analysts were bullish on equities. In 2012, they were collectively bearish! Closer to today's date - most fixed income experts I spoke to half a year ago predicted rate cuts and further falls in yields, and were busy recommending longer duration strategies. Today, with yields having spiked and long-term debt fund investors having burned their fingers, they're mostly crying out 'accrual'. A year ago, most analysts were bearish on Bitcoin. Now, they seem to be collectively optimistic about its future. Traces of the hindsight bias at work here?

Even the legendary value investor Benjamin Graham once famously said that "forecasting security prices is not a proper part of securities analysis".

If most forecasts tend to be off the mark, the natural question that arises is - why do they keep rolling off the conveyor belts like there's no tomorrow? The answer is simple - it's a demand and supply thing. Investors crave forecasts. Without a 'target price' or 'target NIFTY' or 'target 10-year yield' to anchor themselves to, they feel as though they're adrift in a vast, stormy ocean. Neatly packaged numbers and targets lend a false sense of security to investors; and so, the demand for 'forecasts' continues unabated. Naturally, so does the supply!

Philip Tetlock, a Canadian-American political science writer, was arguably the first to do a deep dive into so called expert forecasters, their long-term accuracy, and how they "keep at it" despite their obvious inability to make accurate forecasts over the long -term. He conducted a 20-year study into the accuracy of thousands of forecasts from hundreds of academics, analysts and pundits, and uncovered that experts who had an 80% confidence in their opinions were actually right only about 45% of the time. In other words, you could have done better with a coin toss than by following 'expert' opinions!

Interestingly, Tetlock also uncovered five common 'excuses' forecasters typically made to explain away their misses. Despite coming from an altogether different arena (politics), it's almost eerie how they seem to apply to investment related forecasters, too. Some of these will sound familiar to ardent followers of expert forecaster views on business news channels:

1.    The "If Only" defence: "If only inflation had come in an 3% instead of 5%, my forecast would have been spot on"
2.    The "ceteris paribus" defence (blaming it on something happening outside the model): "The U.S housing market collapsed, so my model was invalidated…"
3.    The "I was nearly right" defence: "Sure, the NIFTY didn't close the year at 12,000. But 10,400 is close enough. And hey, it was a bullish year, wasn't it?"
4.    The "it just hasn't happened yet" defence: "It's just that the earnings cycle hasn't picked up yet… but it will, it will. I wasn't wrong, it's going to happen soon. It just hasn't happened yet"
5.    The "single prediction" defence: "I was wrong about the direction of bond yields this year, but you can't judge my efficacy on the basis of just one wrong prediction"

So, you may ask - if you're not going to invest based on forecasts, how should you invest? To borrow from Benjamin Graham again - "analysis should be penetrating, not prophetic". If you're a direct equity investor, you've got to be capable of applying your own, independent judgment when buying stocks or taking investment decisions. You should be able to devote time, energy, and skills towards developing a deep understanding of the intrinsic value of the company whose stock you're holding, and the industry it's operating in and its broad dynamics. Don't waste time with target prices, predictions and fallacious forecasts. If you're strapped for time, you'll be better off committing your money to a Mutual Fund instead. Buying and selling based on the 'word on the street' will just lead to burned fingers and heartache. Go ahead - resolve to eliminate this all too common behavioural bias this year!