The Problem with Forecasting

The most notable event of the 4th quarter was Donald Trump’s unexpected election victory – a victory that was supposed to send global markets crashing down. Instead markets have rallied strongly into the end of the year, much to the surprise of pundits everywhere.

This apparent contradiction highlights a very important aspect of investment philosophy: One can attempt to predict the future and invest accordingly, or one can seek to identify companies which should do well through a range of future conditions.

Investing on the basis of future predictions is problematic for two reasons:

 

1) No one seems to be able to predict the future with any consistency, not even the experts:

The recent Brexit vote and the US election are perfect examples. No one in the news media or the financial markets gave Leave/Trump a chance of winning. I wasn’t expecting either outcome (though we also hadn’t “positioned” for any specific outcome). I distinctly recall watching an expert on one of the major news wires explain how anyone giving Trump a chance of winning didn’t understand the Electoral College system, and even if Trump won the popular vote, he had no chance of winning the electoral vote. He could not have been more wrong.

The same is true for predictors of market crashes. Not a day has gone by since the last market crash that someone hasn’t penned an article predicting the next one right around the corner. Notably, at the beginning of 2016 RBS came out with a recommendation to sell all risk assets as 2016 was to be a “cataclysmic year”. The MSCI World Index rallied 12.5% in USD from the date of publication through the end of the year.

Make no mistake, there will be market crashes in the future, as there have been in the past – we just don’t know when. Market crashes are the result of collective investor sentiment turning very sour, very fast, and as such are inherently unpredictable. In his recent blog post on market crashes, Ben Carlson writes, “I have no idea how I will personally feel tomorrow morning. How will I ever be able to predict how millions of other investors will be feeling one week, month, year or decade from now?”

Most of the people who make these predictions are highly intelligent – but they are trying to predict the unpredictable.

 

2) Even if one predicts the future correctly, markets don’t always react as anticipated:

Both Leave and Trump victories were expected to be disastrous for global markets, and indeed the initial market reactions seemed to confirm this. In the aftermath of both outcomes markets pulled back heavily (the S&P 500 futures were limit down in Asian trading following Trump’s win), only to recover within 24 hours. With the notable exception of the Pound, most assets have strengthened since both votes.

Imagine having correctly predicted these outcomes and sold everything accordingly, only to have the markets go the wrong way? What do you do then?

A similar outcome occurred in South Africa in 2016: That it would be a year filled with political risks was not difficult to predict, but few would associate that with a strengthening Rand and the outperformance of Rand-based assets.

Of course there have also been numerous cases where markets have reacted as one might have expected: Lehman Brothers, Greece, etc., but this is often not the case.

The point is that market reactions to future events are almost as unpredictable as the future events themselves.

 

The alternative approach is to focus on the causality of investment returns and invest in assets that are likely to deliver good long-term returns under a wide range of outcomes. The causality of returns is clear: Quality and price.

 

A diversified portfolio of consistently profitable businesses, with strong financial positions is likely to deliver good sustainable return over time, through the inevitable thick and thin. Buying these companies at low valuations is likely to further enhance this return over time, as negative prevailing sentiment generally turns positive again at some point, resulting in higher valuations.

So why doesn’t everyone do this? Why do so many experts invest on the basis of predictions?

1)         Predictions tend to be more rooted in stories and narratives, which are far more exciting, intuitive and emotionally compelling than a handful of numbers which often contradict our prevailing emotional sentiment;

2)         News media is in the business of selling sensation and short-termism, which fits nicely with extreme predictions of the near future – so this is all we ever see;

3)         Because there are so many experts predicting every possible outcome every day, it is easy for news media to lend these people credibility by bringing them into the spotlight when their predictions happen to come true – they cherry pick the winners after the fact;

4)         Long-term Investing on the basis of causality rather than short-term stories requires emotional discipline. It often contradicts what we are told by experts on the news all day every day. It’s surprisingly difficult to cut out the noise and stick to a logical process;

5)         There is no investment process in the world that doesn’t underperform at times. In the short-term investment returns are almost entirely sentiment-driven, and no one can plot the path that sentiment will follow. It is at exactly these times that investors tend to abandon their process in favour of whatever story has worked out in the recent past. As difficult as it can be to stick to a logical process, it is even more difficult to do so when short-term results are disappointing.

(This is by no means an exhaustive list of reasons. There are many others.)

Sadly, far too many investors get caught up in stories and short-termism, abandon their process (though many don’t have a process to start with), and their long-term investment returns suffer as a result. The endless quest to time the tops and bottoms of stock markets is a perfect example.

Peter Lynch famously said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

In our view, the best approach is to invest in a diversified portfolio of good businesses at good prices, ignore the noise and the unpredictable swings of the market and allow the force of compounding to do its work as the years roll by.