Imagine you have a friend that makes a lot of commitments but only does 53% of the things he said he will do over the next year. And only 7% of the things he commits to over two years.

You are planning a camping trip this year and a school reunion in two years. How many tasks would you trust your friend with? Probably not many, if at all, or maybe things of little importance.

At this point you are probably asking what this has got to do with investing. A lot more than you think. It’s about forecasting.

 

When I came across an insightful blog post on forecasting by Jonathan Davis I immediately thought it is something that will also help you.

Jonathan graciously agreed for me to use the article in the guest post below. (Emphasis mine)

 

Put Not Your Trust in Forecasts

 

Never invest on the basis of forecasts. So says James Montier, recently anointed the dean of behavioural finance in the UK.

Glance at the index of Value Investing, his superb collection of essays on the subject, and you will find that ?forecast? appears more often than any other, with the exception only Ben Graham. References to the former are as consistently negative as those to the latter are positive.

?The evidence on the folly of forecasting is overwhelming? Montier concludes, whether you are talking about economists or stockbroking analysts. ?Frankly the three blind mice have more credibility than any macro-forecaster at seeing what is coming? is his verdict on economists.

As for analysts, he notes that the average forecasting error in the US analyst community between 2001 and 2006 was 47% over 12 months and 93% over 24 months.

And what does Ben Graham say? Simply this: ?Forecasting security prices in not properly a part of security analysis?.

Judging by the response to my last column, which described John Templeton’s approach to the forecasting business, this is a view that many participants in the securities business share. The only professionally acceptable response to any question on the subject of analyst reports is to say ?Well, I read them ? but only for the data, you understand, not for the recommendations?.

The only problem with all this is that it doesn?t seem to be true. It would be nice to meet a few professional investors who don?t in practice, either implicitly or explicitly, rely quite heavily on forecasts to inform and justify their investment views. This has prompted me over the years to formulate some other rules which I have found helpful in distinguishing between useful and useless research.

Rule One

The first of these is this: ?Don?t rely on what anyone says they are doing. Look at what they are actually doing?.

Just as comment is free, but facts are sacred, so too market punditry is cheap, but actual investment decisions are the only thing that really matter. I recall a meeting of IFAs in March 2003 at which, on a show of hands, a clear majority of those present disputed a claim by Anthony Bolton that his then public bullishness on equities was a contrarian call.

A second show of hands then revealed that, although being bullish was what the majority professed to believe, only a tiny minority of those present had actually positioned their clients? portfolios to reflect that view.

While the audience was talking about loading up on equities, Bolton was one of the few who had already done so. A year later many in the audience were still struggling to catch up with the renewed bull market that they had called, but signally failed to act on.

 

Rule Two

A second valuable rule is ?Never waste any time on investors who appear to be telling the markets what to do?.

Saying something will happen is a good way to generate a headline, but a poor way to make money. Every investment call can at best be an assessment of probabilities.

Those who proclaim that an outcome is a virtual certainty are either:

  • deluded (if they believe their own pronouncements),
  • charlatans (if they don?t believe it, but go ahead and make it anyway) or
  • professionals who are paid to believe it (brokers and headline writers being good examples).

Those who are hesitant and make liberal use of phrases such as ?my guess?, ?the most probable outcome? and so on are the ones talking the true language of the market.

 

Rule Three

A third useful empirical rule is ?Don?t use Japanese experience as proof of anything?.

Many of us have fallen at this hurdle over the years. Just as the great equity bull market of the 1970s and 1980s powered on beyond any possible rationalisation, so too the subsequent 20-year period has been full of commensurate disappointments.

The Japanese economic experience of the last 40 years serves only to demonstrate that Japan, for reasons that are open to analysis, marches to different rules from almost every other market, society and economy. It is the exception to almost every rule in the book. Those who currently claim that the US must inevitably follow Japan into 20 years of debt deflation are breaking both the second and the third rule.

 

If forecasts are no use, then what is the basis on which investors can or should make decisions?

Value has to be part of it. Momentum is also a useful tool: wonderfully consistent as long as it works and then periodically catastrophic when, as invariably it does, it breaks down. Technical analysis, if used as a guide to probabilities, has a place; ditto good fortune.

A good deal of the time however, including most likely the present, markets can appear to be neither obviously dear nor cheap.

Who, though, one wonders, is buying Government bonds today out of unalloyed conviction?

 

Jonathan Davis
http://www.independent-investor.com/

About Jonathan Davis
I have been analysing investment markets for more than 30 years, initially as a journalist on The Times, The Economist and The Independent, more recently as a columnist, author and investment professional. I am Investment Director of Agrifirma Services Ltd and a Non-Executive Director of Hargreaves Lansdown plc. Any personal views expressed on this website, or in the newsletter, are entirely my own.

 

Getting back to our friend.

The commitments your friend keeps exactly matches the forecasting ability of analysts. I know commitments and forecasts cannot directly be compared with each other but I wanted to somehow compare the results of both, to make it clear how unreliable forecasts are.

Not something that inspires confidence. Does it?

In James’ own words: (Emphasis mine)

“One of the recurring themes of my research is that we just can’t forecast. There isn’t a shred of evidence to suggest that we can. This, of course, doesn’t stop everyone from trying.”

 

But as Jonathan says, everyone says that no-one listens to analysts but why is it when a stock misses expectations, it dives, or when an investment bank issues a strong buy the stock price jumps.

I have gotten to the point there I ignore all recommendations from investment banks. But it is not always easy. It is as if humans have an innate weakness for someone that says she knows something about the future. I have to consciously make a point of ignoring forecasts.