Breaking Down an Economic Forecast

In short, it's only natural for investors to seek clairvoyance. Everyone wants to believe in someone else, and everyone wants a "quick fix" to solve for the future. The problem is that many forecasts are ill-timed or inaccurate.

So what should you do when reading or hearing an economic forecast? Merely discard all forecasts as folly? No, not entirely, as there is hidden value in any forecast, as long as you know where to look.

As an investor, when reading or hearing any forecast, you should seek to understand the framework from which the forecast is being made. Take a look at the quantitative and qualitative factors that are being used to arrive at the forecasted result.

The actual process of dissecting the components of the forecast is incredibly valuable, as it forces you to identify the key factors that will likely drive the forecasted results, and to reconcile or discount the projected result from your own interpretation of how economic events will unfold.

Moreover, you can take these components and build upon them. What's to prevent you from subsequently creating your own forecast scenarios? You needn't develop a highly complicated model, per se. Rather, study the components of a forecast that has already been made. Are all of the key factors that will influence the investment results really being incorporated into the expected result? Are certain factors missing from the analysis or improperly weighted into the model? Should other factors be diluted or eliminated from the analysis?

In addition, bear in mind from whom the forecast is coming. Do you really expect a Federal Reserve chairman to tell you that a recession is coming when so much of economic activity is predicated on consumer confidence? Conversely, doesn't it make perfect sense to you that Wall Street equity analysts have consistently rated many more stocks as "buy" than as "sell" recommendations?

Most importantly, when trying to make heads or tails from an economic forecast, you must be emotionally and intellectually honest with yourself. That is much more difficult than it sounds. You battle fear and greed as does everyone else. When you read an investment forecast for high rates of return and a low likelihood of loss that sounds too good to be true, that might well be the case. Likewise, when your hear a forecast for global Armageddon, take a deep breath and break down the pieces of the puzzle before succumbing to the gloomy conclusion.