Forecasting is Marketing . . .

It’s time to market forecasters to admit the errors of their ways
Barry Ritholtz
Washington Post, January 18, 2015

 

 

I come not to praise forecasters but to bury them.

After lo these many years of listening to their nonsense, it is time for the investing community — and indeed, the seers themselves — to admit the error of their ways. Most forecasters are barely cognizant of what happened in the past. And based on what they say and write, it is apparent (at least to this informed observer) that they often do not understand what is occurring here and now.

So there’s no reason to imagine that they have the slightest clue about the future.

Economists, market strategists and analysts alike suffer from an affinity for making big, frequently bold — and most often, wrong — pronouncements about what is to come. This has a pernicious impact on investors who allow this guesswork to infiltrate their thinking, never for the better.

I have been beating this drum for more than a decade. What say we finally put a fork in Prediction, Inc.?

There is a forecasting-industrial complex, and it is a blight on all that is good and true. The symbiotic relationship between the media and Wall Street drives a relentless parade of money-losing tomfoolery: Television and radio have 24 hours a day they must fill, and they do so mostly with empty-headed nonsense. Print has column inches to put out. Online media may be the worst of all, with an infinite maw that needs to be constantly filled with new and often meaningless content.

Just because the beast must be fed does not mean you must be dragon fodder. (More on this later.)

The other partner in this mutually beneficial dance is the financial industry. Forecasting is simply part of its marketing strategy. There are two principle approaches to meeting the media’s endless demand for unfounded guesses about the future. Let’s call them a) Mainstream and b) Outlier.

The Mainstream strategy is simple: Take the average annual change in whatever the subject at hand is and extrapolate forward a year. Voila! You have a mainstream forecast. If you are talking about equities, predict an 8 to 10 percent gain in the Standard & Poor’s 500-stock index. For economic data, project out the past 12 months forward. You can do the same for gross domestic product, unemployment, commodity prices, bonds, inflation, just about anything with a regularly changing data series. If you are feeling puckish, you can shade the numbers slightly up or down to separate your prediction ever so slightly from the rest of the pack — just to keep it interesting. As Lord Keynes once said, better to fail conventionally than succeed unconventionally.

A perfect example is the recent collapse in oil prices. Having completely missed the 50 percent drop that occurred over 2014, analysts are now tripping all over themselves to forecast $40, $30, $20 per barrel in 2015. Since their prior guesswork completely missed the biggest energy story in decades, why should any of us care about their current guesswork?

Then there is the Outlier approach, where a wildly un­or­tho­dox forecast is made. The prognosticator predicts the Dow Jones industrial average at 5,000 when it’s three times that, or hyper-inflation, or $10,000 gold, or a 1 percent yield on the 30-year treasury bond, or a collapse in the Federal Reserve’s balance sheet.

If it comes to pass, the forecaster is feted as a rock star. If not, most people forget. (Although some of us actually track these outlier forecasts). Those in the prediction industry are pernicious survivors. They understand how to play on the human psyche to great advantage. Like the cockroach, they adapt well to conditions of chaos or uncertainty.

There is a flaw in the human wetware that leads to a demand for even more (bad) predictions. The evolutionary propensity that humans suffer from is the desire for specific predictions from self-confident leaders.

This is demonstrated in a wealth of academic data about forecasting track records. Research has shown there is a high correlation between a forecaster’s appearance of self-confidence and believability. Unfortunately, there is an inverse correlation with accuracy, for reasons revealed by the Dunning and Kruger studies on metacognition and self-evaluation. Same with specificity: Studies show that the more precise a prediction, the more likely it will be believed, and the less likely it is to be right. These (and other) factors set up viewers to have the most faith in the people who are least likely to be right.

Perhaps the biggest issue of all is the most obvious: Human beings, in general, stink at predicting the future. All of you. History shows us that people are terrible about guessing what is going to happen — next week, next month, and especially next year.

Why is that? In my last column, I noted that people are error machines, a mess of biases and emotions. They seek out, read and remember only that which agrees with their thinking.The experts are no better than the public at large. Consider the comprehensive examination of expert forecasting performed by Philip Tetlock, professor of psychology and management at the University of Pennsylvania. “Expert Political Judgment” is the book that came out of a study of 28,000 forecasts made by hundreds of experts in a variety of different fields. His findings?“Surveying these scores across regions, time periods, and outcome variables, we find support for one of the strongest debunking predictions: it is impossible to find any domain in which humans clearly outperformed crude extrapolation algorithms, less still sophisticated statistical ones.”

In other words, expert forecasts are statistically indistinguishable from random guesses.

What should investors do instead of paying attention to these unsupported, mostly wrong, exercises in futility called forecasting? I suggest three simple things:

1) Have a well-thought financial plan that is not dependant upon correctly guessing what will happen in the future.

2) Have a broad asset allocation model that is mostly passive indexes. Rebalance once a year.

3) Reduce the useless, distracting noise in your media diet.

It is important for investors to understand what they do and don’t know. Learn to recognize that you cannot possibly know what is going to happen in the future, and any investment plan that is dependant on accurately forecasting where markets will be next year is doomed to failure.

Never forget this simple truism: Forecasting is marketing, plain and simple.

~~~
Ritholtz is chief investment officer of Ritholtz Wealth Management. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture

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  1. VennData commented on Jan 24

    Great article.

    As an American, you have the unique good fortune to benefit when successful private companies become world beaters, since they pay taxes that cover services and investments to government decides upon.

    So? So don’t reach. Don’t gamble. You get the benefits of them and all those foreigners investing here.

  2. Tim commented on Jan 24

    Fantastic article Barry, thank you!!

  3. GregP commented on Jan 24

    Your beef is partly with short term forecasts, and is empirically valid.
    Your beef is also with the unaccountability of forecasters, and that too is valid.

    However, most of what you do at your wealth management firm is predicated on long term forecasts.
    It is not possible to develop a financial plan without some embedded long term forecasts (model inputs) regarding inflation, asset class returns, and taxation.
    E.g. if you didn’t have a forecast for relative asset class returns and volatility, then you wouldn’t have a reason to rebalance. Regression to the mean, a powerful force in finance, entails a long term forecast.

    GP

    • Iamthe50percent commented on Jan 24

      I think you are wrong. You don’t rebalance because of your forecast. You rebalance because you don’t trust any forecast. If you trusted a forecast, you would go all out in that asset class until your forecast says it’s time to switch. That’s not rebalancing. That’s picking winners. I’ve done that and succeeded and with Gold that has no intrinsic value. But it was gambling, not investing.

    • GregP commented on Jan 25

      Without a general forecast for longer term asset class returns (and the attendant risks), there can be no justification for any asset allocation plan.
      You may wish to study up on basic financial planning concepts (see, e.g., the CFP exams).

      “You rebalance because you don’t trust any forecast” is incorrect. Rebalancing is done for two reasons: risk control, and/or a bet on an eventual return to relative historical valuations.

  4. grover commented on Jan 26

    I totally agree that forecasting and forecasters are nonsense. It seems inconsistent that you call out the folly of long term forecasting in the market arena, but seem totally OK with the long term forecasting of climate scientists. The climate is a big complex system full of chaos and random data. The called for disasters have not materialized, and it is a fact that the Outlier “disaster is imminent” forecasters have been wrong so far. Even the “2014 is the warmest year on record” is in doubt–“The Nasa climate scientists who claimed 2014 set a new record for global warmth last night admitted they were only 38 per cent sure this was true. Yesterday it emerged that GISS’s analysis – based on readings from more than 3,000 measuring stations worldwide – is subject to a margin of error. Nasa admits this means it is far from certain that 2014 set a record at all.”
    Though there is NO DOUBT the climate has warmed, I think it is easy and prudent to doubt the long term forecasts of doom. Especially in light of the political solutions proposed.

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