Wednesday, March 18, 2015

Forecasting Folly Revisited

In the bookOne Up on Wall Street, Peter Lynch wrote that many economists are "employed full-time trying to forecast recessions and interest rates, and if they could do it successfully twice in a row, they'd all be millionaires by now."

Lynch then adds:

" far as I know, most of them are still gainfully employed, which ought to tell us something."

Charlie Munger said the following in an interview with Susie Gharib back in 2009:

GHARIB: "When do you see the recovery coming?"

MUNGER: "We don't have any special ability to make that kind of macro economic prediction."

The good news is that successfully predicting macroeconomic outcomes isn't required for investors.

In fact, trying to do so is a distraction.

There's also the following dynamic to consider:

"Because there is no way to hold financial forecasters accountable for their incorrect predictions, they get more out of making wild ones. Wild predictions pay because the downside of being wrong is zilch, but the upside is lifelong fame."

So some in the business of making predictions are, in some ways, simply doing what's necessary for marketing purposes.

Prognosticators would argue otherwise but, given the complexity of the system they're attempting to understand, to me it seems effectively impossible to reliably make useful predictions.

Figuring out what a good business is worth and what to pay for it isn't an easy task, but at least it's not effectively an impossible task.

In 2003, Charlie Munger said the following at a speech to the University of California, Santa Babara Economics Department:

"...there's too much emphasis on macroeconomics and not enough on microeconomics. I think this is wrong. It's like trying to master medicine without knowing anatomy and chemistry. Also, the discipline of microeconomics is a lot of fun. It helps you correctly understand macroeconomics. And it's a perfect circus to do. In contrast, I don't think macroeconomics people have all that much fun. For one thing they are often wrong because of extreme complexity in the system they wish to understand."

Consider the findings of professor Philip Tetlock.

A study by professor Tetlock found that those "who earn their livings by holding forth confidently on the basis of limited information...make worse predictions about political and economic trends than they would by random chance." In fact, "the most famous and the most confident" are generally the worst at making predictions.*

According to Tetlock, the best forecasters tend to be more like foxes than hedgehogs.**

So ,while economic forecasting has certainly become more sophisticated, that doesn't mean they're becoming more useful.

"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen." - Warren Buffett in the 1994 Berkshire (BRKa) Hathaway Shareholder Letter

Practically speaking, at least to me, it's mostly a waste of energy trying to makes guesses -- even very well informed guesses -- about what might happen in an uncertain world.

The focus should be on figuring out what's likely to do well over a longer time horizon even as the inevitably unpredictable world will bring many surprises and challenges. Will a good business be able maintain all or most of their competitive advantages for a very long time? Better yet, does the business have characteristics that make it likely those advantages will even be strengthened over time?

"If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results." - Warren Buffett in the 1994 Berkshire Hathaway Shareholder Letter

The stock market did just fine over the past century or so despite what almost certainly be a whole host of major economic and political shocks. Stock prices, will no doubt respond to these events. That a crisis of some kind -- or maybe even several -- will undoubtedly emerge in the coming decades hardly makes it impossible to invest. The risks of attempting to time the market are not small. In fact, attempts at timing will likely do more harm than good.

"The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions." - Warren Buffett in the 2012 Berkshire Hathaway shareholder letter

Keep in mind that 17,320% doesn't include a century of dividends.

Time in the market generally beats timing the market in the long run.

Stick to what can be understood then pay a price that reflects uncertainties. That there'll be challenging economic environments and upheavals is almost a given. There will never be any guarantees. Future difficulties may exceed all from the past century or so.

Being frozen by this reality is no investment strategy.

Expect market fluctuations. Forget about reliably predicting when and by how much. Ignore those who try to do so.***

John Kenneth Galbraith once said: "There are two kinds of forecasters: those who don't know, and those who don't know they don't know."

Munger and Buffett haven't needed to be brilliant forecasters to get investment results.


Long position in BRKb established at much lower than recent market prices

Other related posts:
Forecasting Folly
Henry Singleton: Why Flexibility Beats Long-Range Planning
Forecasters & Fortune Tellers
Charlie Munger: Snare and a Delusion
On Forecasting
James Grant on Economic Forecasting

* An excerpt from Susan Cain's book Quiet.
** Professor Tetlock puts it this way: "Hedgehogs are big-idea thinkers in love with grand theories" while "foxes are better at curbing their ideological enthusiasms." He goes on to say foxes tend to not over-simplify and are more aware of the limits to their arguments. As a result, they become less prone to mistakes.
*** I think this quote by Charlie Munger on macroeconomic predictions captures it well.
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