Wednesday, March 10, 2010

Forecasting Forecasts

We spend a lot of time reading forecasts. The financial news media is rife with new articles every day that take a position on the near-term future of inflation, interest rates, and stock prices. But are these forecasts of any use? James Montier, an author on the topic of behavioural finance, says no.

He has compiled and aggregated past forecasts for a number of popular financial metrics. The following chart illustrates how well forecasts of inflation have approximated actual inflation over the last several decades:

Note that the forecasts of the deflator actually lag the actual deflator! This forecast is telling you what happened, rather than what is about to happen!

Next, consider forecasts of the US government 10-year bond yield:
Once again, the same thing seems to be occurring, where the forecast is simply telling us what has already happened! Finally, a similar phenomenon occurs when forecasts of the S&P 500 are considered:
Of course, it should be noted that these forecasts are considered in the aggregate, whereas some forecasters may be able to consistently outperform others. However, there does appear to be a lack of supporting evidence that some forecasters are clearly superior.

Sixth-century BC poet Lao Tzu remarked that "those who have knowledge don't predict" while "those who predict don't have knowledge". So if forecasts are so useless, why do we spend so much time making them and reading about them? This topic will be explored in a future post.


editor said...

Nice article. My guess for your second segment is people like having a forecast so they can feel safe and have something to rely on. Difficult questions seem a lot easier to answer if you have a forecast, however wrong it may be.

But I think value investors must remember, if something is to difficult we can simply walk away. As Buffett says 'The stock market is a no-called-strike game. You don't have to swing at everything--you can wait for your pitch.'

segemran said...

very interesting topic Saj

Joe O'Brien said...

I just realised how long it has been since I read a post by Barel. Is he busy with the fund?

Anyway, great topic. It is great you shine a light on his kind of academic research that wouldn't get any airtime for obvious reasons.

Daddy Paul said...

Good read. I would not waste my time trying to predict what is going to happen (Except interest rates will rise that one I think you can take to the bank). I do invest based on what is likely to happen. Buy low sell higher.

Saj Karsan said...

Thanks, guys!

Hi VL, good eye. Yes, Barel hasn't made a blog contribution in several months! Busy at the large value firm he now works for.

David Templeton, CFA said...

A late comment; however a nice post Saj.

Saj Karsan said...

Thanks, David!