This article forms part of our weekly TW3 newsletter, you can see the full article here.
Forecasts are Fishy
On the rare occasion Nic logs onto Facebook, he without fail comes across a meme shared by a middle-aged woman centred on wine, chocolate, and/or the uselessness of the men. This week’s meme did not disappoint!
Aside from the sheer absurdity of the cartoon (the fish has a fishing rod!), it ties in nicely with the theme Nic was going to write about this week anyway – the unfortunate obsession investors have with forecasts around this time of the year.
You could say that an investor needs forecasts for the year ahead like a fish needs a bicycle. When the calendar flips over from December to January, a bunch of industry professionals are asked what they expect for the coming year. Year in, year out, the majority of these forecasts turn out to be incorrect. Year in, year out, investors lap up their forecasts anyway.
So why do investors continue to read articles like the one above even though they rarely if ever contain any valuable insights? For the same reason there’s a horoscope section in each newspaper – the future is uncertain, and it is natural to want to have an idea of what the future holds.
Investors should consider articles forecasting the financial future as light entertainment rather than anything that can aid investment decision making. At the beginning of 2008 many experts were expecting local shares to rise a healthy 10% for the year ahead, they ended up falling 40%!
Revisiting The Outcome Bias
The reason why most forecasts don’t pan out is that there is too much complexity in the world, and forecasts are often based on incomplete or inadequate information. Former US Defence Secretary Donald Rumsfeld put it best “there are known knowns, there are known unknowns, and there are unknown unknowns” – and don’t forget unknown knowns!
This is why it can be misguided to judge decisions on their outcome rather than by the process used to make the decision. Randomness can make an otherwise good decision look bad, and it can also make an otherwise bad decision look good. You could argue that somebody who buys insurance but doesn’t end up making a claim wasted their money. You could argue that somebody who took their lifesavings to the casino and doubled it by betting on red at the roulettes table is a genius. In the short-run, luck can work with you and it can work against you.
You can save a heap of money by cancelling your insurance coverage – as long as you’re lucky and nothing bad happens. You can make a heap of money speculating on investment fads in the short term – as long as you’re lucky and nothing bad happens. The issue is that eventually your luck will run out and something bad will happen. At Stanford Brown our portfolios are constructed to minimise the role of luck in client outcomes by focussing on the largest risks to client portfolios. The difference between an investor and a speculator is their priorities. Investors worry about risk, speculators worry about returns. When you focus on risk, the returns take care of themselves. When you focus on returns, the risks take care of themselves!