Taking Stock – the predictions business

“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know”
John Kenneth Galbraith

“Every Saturday morning from August to May, four mates and I take it in turns to throw in a fiver, and each of us picks a football team to back during that weekend’s fixtures in an accumulator. We decided to do this originally in order to have an excuse to meet for a lavish dinner once a year to spend our annual winnings. Sadly results have transpired to be more Big Mac than Le Gavroche. In three and a half years, our bet has come in twice. With all due respect to Adrian, Iain, Neil and Pete – we would have been better off outsourcing our selections to a monkey with a dartboard.

Why am I telling you this? Therapy, primarily. But also to iterate that predicting future outcomes is really quite difficult. Even if human beings consistently overestimate their ability to do so. Bookmakers’ business models are predicated on it.

Howard Marks’ brilliant recent memo “The Illusion of Knowledge” focuses on the futility of forecasting, and if you can get hold of a copy, I really would recommend giving it a read. Admitting that we have no real idea about future world events, or the implications for the market may be an uncomfortable exercise. But I think it an absolute necessity – unforeseen events, or rare occurrences happen more than you’d expect.

Let’s take an example that Mr Marks includes in his piece – the 2016 presidential election. The working assumption was that Hilary Clinton was going to prevail. Consensus agreed that a Trump win would be bad for markets. We all know what happened of course. Mr Trump won the race for the White House, and US equity markets went on a tear – rising by 19% in 2017. To take another example closer to home, while the Brexit referendum was deemed to be a closer run thing, an outcome of “Remain” was favoured with the implications of a “Leave” vote deemed to be disastrous for the UK market. It was some time in the afternoon of the 24th June 2016 that the UK market moved into positive territory having been down heavily in the morning after the referendum, and it finished the day well in the green. Given that a high proportion of the companies listed in London earn revenues in currencies other than Sterling, the weakening pound meant that those company’s earnings were “worth more” and share prices went up. Not many market participants flagged this as a possibility ahead of time, and it took a while for this realisation to creep into the collective psyche.

Even if we are right about the outcome of a certain event therefore, it does not follow that “A equals B”. That is to say, that if “A” happens we cannot in advance necessarily determine the market reaction. To do so would rely on our ability to predict the reaction of hundreds of millions of market participants around the world to said news. I’m certainly unable to do that in real time. 

I don’t think that acknowledging this is anything to be afraid of. Knowing that the future is unknown and unknowable doesn’t just check the ego, it also forces us to introduce a level of discipline into our investment process that can help in mitigating against worst outcomes. Here are some rules of thumb I keep in mind to guard against the worst implications of needless forecasting…”