February 29th, 2024
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No Crystal Ball Required

Protecting and building wealth isn’t about being right every time, all the time.

January’s Investment Insights was about looking backward, at the last twelve months. February is about looking forward, or forecasting. Everyone makes and uses forecasts. Sometimes it is as clear as preparing a budget for your family or business. Other times it can be quite murky. Choosing a career to pursue, for example, relies on a lot of vague guesses. What type of work will you enjoy? What are your prospects for finding employment? How likely are you to achieve your desired standard of living? Forecasting is an unavoidable aspect of life.

Yet forecasting is challenging, imperfect and fraught with risk. It is a necessary evil in every sense of the phrase. Forecasts are almost always wrong. Even when someone gets it right, there is little or no consistency in forecasting ability over time. Few are ever held to account. This does not mean, however, that forecasts are worthless. The value lies not in whether a forecast is perfectly correct or not, but rather in how it is used.

If forecasting is such trouble, why even bother? To begin with, you have to aim toward something. Otherwise, you are either aiming unknowingly or altogether aimless. It is hard to know which is worse. For an organization, an aim is important to direct a large, diverse group of people toward a common objective. For an individual, an aim creates a sense of purpose that benefits mental and physical health. Nothing less than how we see the world is influenced by our aim. If you would like to sit down, you see a wooden chair. If you would like to start a fire, you see a fuel source. If you would like to defend yourself, you see a weapon.

In finance, any decision you make is based on expectations for the future. Profiting from an investment requires predicting its future price. Financial planning relies on assumptions about future income, spending, inflation, tax rates and returns, to name just a few variables. Taking out a mortgage is based on expectations of the home’s future value and your ability to repay the loan.

What makes forecasting so difficult is that the world is comprised of seemingly limitless complexity. In a simple world, X happening would always lead to Y happening. In reality, a near infinite number of variables can lead to Y happening. Worse yet, the influence of each variable changes over time. Even worse, the interaction of every combination of variables also impacts Y. Worse still, the influence of these interactions changes over time as well. Before long, the complexity is simply overwhelming.

But wait, it gets even worse than that. Systems are inherently dynamic. Say that you could actually predict the stock market with perfect accuracy. It would never work. Immediately, actions taken based on the forecast would change the underlying structure of the market and render the prediction obsolete. Like a dog chasing its own tail, on and on this would go without end as the chase for perfection only pushes it further away.

The conundrum then is that forecasting is simultaneously necessary, important and difficult. What to do about this? While a forecast will never be perfect, forecasting can be valuable 1. Among many ideas, one is to build multiple forecasts, some of which are favorable and some of which are unfavorable. Always keep base rates, or the typical outcome in a given situation, in mind as you forecast. Using them as a starting point forces you to think through your forecast. Perhaps expecting an atypical outcome is justified. Other times it may just be wishful thinking.

The best, most serious study of forecasting that I am aware of is Superforecasting: The Art and Science of Prediction by Philip E. Tetlock and Dan Gardner. Lessons from that work include: balance between inside and outside views (similar to using base rates), neither underreact nor overreact to evidence, understand the counterargument(s) to your case, force yourself to use numeric probabilities and conduct post-mortems.

The best way to solve the conundrum is to use the forecast correctly. Forecasting isn’t about correctly predicting the future, but rather about understanding all possible futures and identifying the key variables determining which will become reality. Do not become overly reliant on a single forecast nor ascribe to it a degree of accuracy it does not and will never possess. Rather, use forecasting to create a reasonable range of outcomes to prepare for, assign each a probability, plan for how you would act in each case and then adjust accordingly as developments play out.

Pay special attention to risks and downside scenarios. Appreciate the seemingly infinite complexity of the world – and plan for it. Consider the consequences of your actions if your forecast is wrong. If you are making a risky, permanent decision, a higher degree of confidence (or tighter range of outcomes) is required from the forecast. In the inverse situation, a looser forecast would suffice.

Seek out and identify forecast-breaking assumptions. These are things that everyone knows everyone knows. You don’t even think about them when forecasting. You will have to suss them out. When these assumptions prove wrong, the consequences can be disastrous, like pulling the wrong block from the Jenga tower. Prior to the Great Financial Crisis, everyone knew everyone knew “home prices only go up.” When home prices subsequently fell 27%, it nearly crashed the global financial system.

For protecting and building wealth, a big determinant of long-term success is simply surviving. When forecasting, it is better to be roughly right than precisely wrong. In the former case, you’re perhaps a little bruised and battered, but still okay. In the latter case, you’re dead. There’s no coming back from that, I don’t care how skilled you are. An underappreciated feature of investing is that just being more-or-less “okay” (sometimes a little good, sometimes a little bad) every year for many years can yield a truly exceptional long-term outcome. That is how compounding works.

Of course, you’ll need to forecast along the way. You can’t avoid it. Just build in a margin for error, within the forecast itself, within how you use the forecast and within your overall asset allocation. Protecting and building wealth isn’t about being right every time, all the time. That is impossible, though it never stops people from trying. Rather, protecting and building wealth is about your ability to patiently execute a disciplined process over very, very long stretches of time. No crystal ball required.

Thoughts? I would love to hear them. Email me at investmentinsights@zuckermaninvestmentgroup.com.

Written By Keith R. Schicker, CFA

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  1. This is essentially Eisenhower’s quote: “Plans are worthless, but planning is everything.”