Professor: "You'll see that the software allows you to determine what variables play the most important roles in forecasting. You can then rebalance what weight you want to put on say, oil prices, for future GDP growth estimates in the formula."Student: "What if the variables the model says are unimportant now in predicting the future become important in the future, or if your estimates for the inputs are way off?"Professor: (Pause) "You have to make assumptions that some sort of consistency will take place into the future -- that what worked in the past will work in the future. Frankly, forecasting works better at predicting the future when the future follows the same path; it's the turnarounds that forecasting has trouble with."
Years ago in my "economic forecasting" class, the preceding conversation took place. The implications of this point didn't sink in at the time.
Everybody makes forecasts. Some are a little more scientific, using software, surveys and data. Others just make guesses, educated or otherwise. Often the "professional" forecasts are no better than the guesses. It's a running joke that economists have predicted 12 of the last five recessions.
Most business decisions are made based on some forecast, formal or not, of what the future will look like. Buildings going up around the country exist because the builders think they can sell or rent the units at prices that make the venture profitable. None of the backers are forecasting sharp declines in rental income or sales prices, or else they wouldn't be building, any more than you would invest in the stock market today if you thought earnings in the
would be 30% lower next year.
Fund investors have something in common with managers and executives. They look at what has happened over recent years, and they forecast that behavior into the future.
With investors, if the S&P 500 were up an average of 15% a year for the last five years, then it is a far better investment than bonds if bonds were up only 7% a year for the last five. With executives, if air miles flown per person have gone up 10% a year for five years, then they need to start buying planes and adding gates to ramp up for the expected future traffic.
It's the exact same error whether an investor makes it with his $75,000 portfolio or a CEO makes it with a $5 billion loan.
Why is it so common to continue recent patterns into the future? It's in our nature to discern patterns. Intelligence tests often use pattern recognition quizzes to gauge aptitude. "What number is next in the series: 1,3,5,7...?" The correct answer is never some unforeseen reversal in the pattern.
Let's say an investor is presented with a pattern of mutual fund performance figures from three successive years: +15% in year one; +20% in year two; +17% in year three. Then, the investor is asked what next year's likely performance would be:
Most would chose "D" -- at least that's how they vote every day with their money. The other choices don't seem to come from the same stream of similarly positive data. Investors and executives think predicting the future is critical to make capital allocation decisions. So important is the future that both investors and CEOs turn to outside professionals who are expert in predicting these future patterns.
For investors, these seers are advisers, analysts, reporters, brokers, gurus, economists, executives and authors with expert methodologies to predict tomorrow's numbers. Investors then make capital allocation decisions based on these forecasts. For executives, these futurists are advisers, management consultants, accountants, marketing researchers, economists, statisticians and forecasters.
These professional pattern predictors do what unprofessionals do: They predict the future on the basis of the recent past. Only they use more inputs and complex reasoning.
For investors, experts predicted continued growth in all the stocks that were growing the fastest. With executives, the experts called for future growth in airline traffic, Internet usage, wireless call volume, advertising dollars, and energy and stock trading activity. Executives followed their hired experts and built business to profit from this very rosy future scenario.
Unfortunately, in the real world, a pattern such as 1,3,5,7, can be followed by a -4. Airline traffic fell, net usage slowed, stock trading contracted, and people didn't spend 40 hours a week on their cell phones. Companies that didn't leave any room in their plan for the future being anything but a better version of the past are now in bankruptcy, sitting on mountains of excess capacity and debt. Investors who only planned for growth on top of growth are left with severely decimated portfolios -- all victims of the unpredictable and unforecastable "turnaround."
A few months ago, some executives and investors seemed to be planning for a new scenario, one that forecasted and modeled the last three years into the future. The
would surely go to 5,000 if you follow that pattern, and Treasury bond yields could go to 1%. Corporate spending will keep getting cut back, and all of the fabulous late-'90s companies would go bankrupt. It was the exact opposite forecast of Dow 36,000 and unlimited prosperity with companies worth close to $500 billion on their inevitable climb to $1 trillion and beyond.
All forecasting is not baseless quackery. You can learn from the past, but you need respect for the uncertainty of the future. A prediction of boundless growth is generally just as speculative and unlikely as one for Depression-era collapse, and portfolios designed exclusively for either will fail.
The big returns come from predicting something and placing a big wager on it, so the temptation will always exist to focus your bets and not be a wishy-washy manager. But predictions are not the mathematical certainties like the answers to the pattern questions on the tests, and big bets made on predictions can lead to peril.
Try to manage your portfolio in such a way that it will make some money if things go well but won't go bust if they don't. Executives at countless telecom, tech, airline, Internet, media, cable and energy companies who were a little too confident in the experts' forecasts should follow the same advice, but it's not as critical. When they run companies into the ground it's generally not their money at stake, yet they benefit from the upside if they bet right.
You don't have that luxury with your portfolio.