In today’s hyperconnected, information-driven world, investors are steadily bombarded by economic and stock market forecasts. Or, it could be more micro, such as a multi-year forecast on a company’s revenue or profitability. Whether bullish or bearish, the onslaught of proclamations of what is apparently going to happen, influences our opinions and drives our decisions.
One of my favourite Warren Buffett quotes is on economic forecasting: Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future. Characteristic of his lighthearted style, he manages to pack in humour and wisdom in one sentence.
But predictions are everywhere. So how can we use them to make better investment decisions?
Dan Kemp, the Chief Investment Officer of Morningstar Investment Management EMEA shares his wisdom.
What to realise: The economy is not the same as the capital market. Making accurate forecasts about the former may not help you create returns from the latter.
Most stock markets are dominated by companies that are global in nature. For example, the largest companies listed on the U.K. market derive approximately 70% of their sales from outside the U.K. Consequently, the ever-growing tide of economic forecasts related to Brexit, are likely to have limited relevance for these companies or consequently for investors.
A long-term valuation driven investor must believe that the price paid for an asset is the most important determiner of future returns.
What to realise: Indicators are probabilistic. Recently, the inverted yield curve in the U.S. pointed to the scenario of the cost of borrowing money over the long term being lower than the cost of borrowing over the short term. This typically indicates that investors expect significantly lower interest rates and / or lower inflation in the future. For this reason, yield curve inversion often indicates a future recession and is used by some as a signal for investors to take less risk.
If there was an entirely predictable way of forecasting recessions, the impact of that recession would be almost immediately reflected in asset prices, reducing the benefit of reacting to the signal. The future is probabilistic, rather than deterministic. So we need to consider a range of potential outcomes and their likelihood rather than a single path. This is difficult because as humans we tend to overweight the likelihood of more vivid outcomes and underweight the probability of less interesting paths. However, by considering a range of possible outcomes and assigning probabilities to each, we have the best chance of understanding the impact of future events on a portfolio.
What to realise: Forecasting can be a hard habit to break. I use the word habit deliberately since often we are not even aware that we are making such forecasts as they are such a normal part of everyday life.
As humans we tend to be over-confident in our views and hence these forecasts can lead to poor outcomes. A great example of this problem is Brexit. The outcome of Brexit remains unknowable to most of us, but we all have an expectation. Ditto with the General Elections in India. Since forecasting is a hard habit to break, it is helpful to have something else to focus on. Put your focus on assets that are attractively valued and likely to deliver higher-than-usual returns over the long term. This approach leads us to place less emphasis on the short term and reduces our susceptibility to forecasts.
What to realise: Any forecaster worth their salt should be able to provide a probability level with the predictions they make, those that don’t should be treated with great scepticism.
The future is unknown. Nothing can be predicted with 100% certainty over a specific timespan (even death and taxes can normally be delayed). So it is essential to understand the degree of confidence the forecaster has in his/her predictions. A prediction made with a 60% probability is likely to be wrong almost half the time and is, therefore, of little use to an investor making a single decision based on that prediction.
Should you forecast?
We have dealt with forecasts flung at us from various quarters. But what about a personal take? Preferably, no. You would do well to remember the Danish proverb “It is very hard to predict, especially the future.”
Instead, try to decipher whether the long term expected return is embedded in the price of an asset. This will help you understand whether the current price represents an attractive opportunity or a perilous trap.
