Investment Forecasts: Known Unknowns

December 29, 2009

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Investment Forecasts: Known Unknowns

End of Year Epiphanies

At the end of every calendar year we experience a rush of forecasts on the likely direction of various markets and stocks for the next year. You can find thousands of such forecasts on the internet and you can’t pick up a paper without someone or other opining on the subject. In fact, no matter what your preference, you’ll doubtless find someone out there predicting whatever you want.

The uselessness of these predictions was carefully explained by the Ancient Greek philosopher Socrates, two and half thousand years ago. Not letting death, the lack of Ancient Greek stockmarkets or the fact he lived in an economy based on slavery get in the way of a good analogy, Socrates noted that he, at least, knew what he didn’t know. Which in investment analysis terms is about as close to an epiphany as you’re likely to get.

From Socrates to Rumsfeld

Socrates seems, as far as we can tell, to have spent his life in philosophical musings, preferring to spend his time asking the supposed wise men of Athens for their insights rather than doing anything more economically useful. His conclusion was, largely, that they didn’t know very much – an insight that echoes down the ages. They, on the other hand, decided that they didn’t like a smartass and the result is a lesson to would-be gadflies the world over.

In particular he seems to have annoyed the powerful by informing them that he knew something they didn’t. Having already upset them by showing up exactly how dim they were he then compounded his crimes by revealing his secret: “I know what I do not know”. If this sounds familiar, you’d be right:

“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.”

It’s long way from Socrates to investment analysis via Donald Rumsfeld but I think we’ve just managed it.

The Known Unknowns of the Market

Socrates’ known unknowns are important for markets, because each of us can know – with something approaching certainty – that one of these is that there are people out there who know more about investing than we do. If different participants have different abilities when it comes to analysing and interpreting information then, by definition, the markets can’t be strongly efficient. Even if we’re all rational we aren’t all equally gifted.

However, if we are all rational then, if we recognise that other people know more than we do, we ought to stop investing actively. After all, if investment analysts and institutions have this much of an edge on us it makes no sense for anyone without demonstrably superior investing skills to try and compete with them. So if we’re rational maximisers then we ought to buy index trackers and content ourselves with sitting on the sidelines watching the heavyweights slugging it out.

Extending this argument, as the least good investors stop competing, the remaining participants will themselves divide into the best and worst groups with the winners taking the spoils. Once again members of the worst group should, rationally, stop investing actively and this process of winnowing should carry on until there is only one investor left. Who then has no one to invest with, leading to the heat death of efficient markets.

The Unknown Unknowns of the Market

Now, obviously, this isn’t what’s happening. Millions of people continue to dabble in active stockmarket investment in spite of having no obvious ability to outperform markets. Even better, they carry on investing even when they’re losing money, failing to learn from their mistakes. These people, who clearly don’t know what they don’t know, are the inefficient grit in the gears of the efficient market. Bless them, because without them value investing couldn’t work.

The behavioural weaknesses of market participants – certainly their overconfidence and lack of insight into the reasons for past underperformance – are clear and powerful drivers of market inefficiencies. Exploiting these inefficiencies should be the goal of all right thinking investors, which means that we need to be constantly looking for where people are behaving most irrationally.

These manifest inefficiencies mean that making anything approaching a detailed forecast is almost impossible. The end-of-year forecasting bonanza, which is largely driven by the need to fill column inches, is one of the odder and more pointless activities humans engage in, somewhere up there with bog-snorkelling and cheese rolling.

Random Forecasts

There’s so much data out there it’s possible to find evidence to support any theory you might like. Someone, somewhere, will be right – which is nice for them, but not much use for the rest of us trying to avoid losing money. Of course, the people who ought to be best at predicting the motion of the stockmarket ocean are those that are paid for the experience: security analysts.

Going all the way back to the original work of Alfred Cowles’ Can Stock Market Forecasters Forecast? in 1932 the evidence for analysts outperforming the market is ambiguous, to say the least. Possibly the best gloss on the situation comes from this paper by Ericsson, Anderson and Cokely who identify that the best analysts do seem to have an edge in making predictions but that seems to be linked to extremely constrained areas of expertise, is not generalisable to wider markets and is too small to be exploitable when costs are taken into account:

“With the possible exception of the advantage of trading by insiders, the advantage offered by expert investors is too small to allow profitable transactions, yet sufficiently large to show reliable gross abnormal returns, before the costs of the transaction are subtracted. From the point of view of expertise research we find that there are consistent individual differences among experts, with experts exhibiting specialization, and demonstrating superior and reproducible investment and forecasting performance”.

So as it stands even the best brains in the business don’t have the ability to outperform the markets so, naturally, the rest of the world – which has next to no experience of market behaviour – expects to outperform the analysts, heaven help us. The only thing that the mass of return seeking mavens has to offer as an advantage over the analysts, who, as we discussed in Rise of the Machines, have the most powerful computer systems, the best researchers and the cleverest algorithms around, is their willingness to outwait the latest trend. Obviously this is, generally, the only attribute they’re not willing to use to their advantage.

Hemlock for the Pundits

The end-of-year forecast frenzy is simply a bit of temporally induced fun which shouldn’t be taken seriously. Recognising not just that we don’t know very much but that most of the people telling us what to do don’t know very much either is an important step towards freeing ourselves from the straitjacket of our social conformity and becoming intelligent investors.

Socrates, of course, ended up drinking hemlock and committing suicide after annoying too many powerful people. That seems like a step too far in search of a perfect investing strategy but being willing to go against the trends and to ignore opinion is absolutely critical. So if you must read the pundits’ predictions at least do so usefully: write them down and then compare them with what actually happens.