Forecasting is Guessing

The acclaimed analysts at banks and stockbrokers spend countless hours building financial models predicting the future.

Mark Twain said it well, “prophecy is a good line of business, but it is full of risk”. While claiming to know the future is impressive and earns some fees, the unspoken truth is that a forecast is nothing more than a guess.

Great managers don’t forecast

CEOs and executives are understandably reluctant to provide forecasts. A good CEO knows that the future will be impacted by a number of different, unpredictable variables. Instead of committing to specific short-term forecasts, time is much better spent on strengthening the key drivers to generate long-term value.

“I am a better investor because I am a businessman; and I am a better businessman because I am an investor.”

Warren Buffett

The future is non-linear

Like great managers, the best investors don’t rely on forecasts to make decisions. Because the future is non-linear, trying to define it in a single row of a spreadsheet is futile. The great capital allocators spend their time understanding (not defining) the core variables influencing a business and whether the current price accounts for the uncertainty the future holds.

“You’ve got to be able to look at the deal and know what it hinges on to know if it works or not. If you realise the key component works then use the numbers to help you prove it.”

Sam Zell

Financial models are fragile

Mohnish Pabrai says that if you need a spreadsheet to explain an investment thesis then it probably isn’t compelling enough. This isn’t the most practical advice but before you invest next time, try explaining it in 30sec to someone with no financial literacy.

Spreadsheets are very useful (essential) for analysing a company’s history, its industry, even modelling out different return/profit outcomes. Financial models should help us understand a business but shouldn’t be our ruler. Great investments should be obvious.

The smaller the gap between value and price, the more precise we need to try to be with our assumptions. When we leave very little room for error (margin of safety) and use lots of assumptions (good chance of being wrong) we are treading very fragile ground.

“If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it.”

Warren Buffett

Most forecasts are useless anyway

Strangely enough, a forecast is only really helpful if it is predicting something very few are expecting. If the prediction is line with the crowd than its most likely reflected in the price making is very difficult to profit from anyway.

“Extreme predictions are rarely right but they are the only ones that make you big money’

Howard Marks

The institutional imperative means there is very little incentive for analysts at big banks and brokers to provide a recommendation which is truly different from their peers. If everyone is already acting on the forecast then it is very hard to profit from it.

It’s ok NOT to know

I feel for advisers employed to have an opinion on everything. Where are interest rates headed? Whats GDP Growth for the next 5 years? When will the US raise interest rates?

When someone is paying you for advice it is very hard to say ‘I don’t know’. Truth is, people much smarter than me have tried to forecast this stuff for centuries — and failed. I recently read the AFR Rich List and while the entrants sources of wealth are varied, very few of the members can attribute their billions by predicting stuff.

Most people have very narrow fields of competence and its actually a battle to stay within it. My competence is particularly narrow so I remind myself regularly that the truth is all that matters and its OK to say I don’t know.

Embrace the uncertainty

Instead of relying on forecasts, we rely on Margin of Safety. Uncertainty about the future is ok as long as their is a large enough distance between price and value or in other words, some room to make mistakes in our analysis.

Uncertainty about the future is an investors friend. A predictable earnings stream is usually built into a price. Uncertainty creates emotions which distorts prices so without uncertainty there can be no bargains.

“Low risk and high uncertainty are a wonderful combination. Risk is the potential for capital loss, while uncertainty is a wide range of possible outcomes. When The Street gets confused between risk and uncertainty, it is time to profit handsomely from that confusion”.

Mohnish Pabrai

If you can’t control the future, why bother trying to define it? Like anything in life, we are far better at focusing on the things we can control. Making guesses about the future might be fun, but it is a low value activity. The great investors avoid forecasting and so we try to also.

Credits: Mark Twain, Warren Buffett, Sam Zell, Howard Marks, Mohnish Pabrai.