“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.
1. Most things don’t matter.
To state the obvious – if you make fewer predictions, then you are going to be wrong less. The vast majority of events simply don’t matter when it comes to the path of the stock market so making predictions is often futile. It may be difficult in a social media age, but none of us need to have an opinion on everything.
Making too many predictions can have worse consequences than just tying you up in knots. As we have seen, market reactions to events can be completely counter-intuitive. If you are making big bets based on a certain outcome, you can be right on the event and wrong on the market reaction. Which would be pretty infuriating I’d imagine.
2. Maintain a laser focus on the long term.
History, which is an imperfect guide but the best that we have got, shows that market returns become more predictable when we look back over longer time frames. While they naturally oscillate wildly over one year depending on how fortunate or not you are (the black line in below chart), annualised returns taken over twenty-year periods are relatively consistent (red line in the below chart).
Being a genuinely long-term investor therefore has two potential benefits: 1. Your likelihood of a positive outcome increases materially; and 2. The predictability of annualised returns increases too
Diversification may not be having a great year, but the best way to guard against inaccurate predictions is by having a collection of investments which are genuinely diversified within your portfolio. One of the most difficult elements of being a professional investor is that in order to embrace diversification, you will naturally have to add positions to your portfolios that you might not be all that positive on at any given time – maybe high quality short dated bonds, gold or commodities. You need to be prepared to hedge your base case. If you don’t, you are placing all of your chips on one number.
4. Be wary of narratives
If you have ever been on a sales course, you will know that people buy stories. If you are in the room with a particularly compelling salesman, it is easy to be swept up in a narrative – this is a bias that I have recognised in myself in the past. It is for this reason that most of the time, I prefer to remove myself from interacting directly with fund managers or company CEO’s and instead look at the output of our research team dispassionately.
Without getting into a debate about the merits of cryptocurrency, one thing that fascinates me about the asset is how evangelical its investors can be. Without a proven utility (which may arrive one day), the buy case can only be constructed based on narratives about the future which may or may not come to pass. Narratives which are pushed hard by those who truly believe.
Nonetheless, investments based solely on stories are dangerous beasts.
5. Recognise when you are wrong, and move on
Another tricky one. People don’t like being wrong, but if you are investing in individual companies sometimes your investment thesis won’t play out. It can be tempting to dig our metaphorical heels in and entrench our position further in our minds – but this can be ultimately unhelpful. If you are in the position of investing in individual shares on your own behalf, try and set some rules in advance for these holdings that force you to reassess in certain given circumstances. Making rules for ourselves in advance can lead to better decision making when emotions are high.
I have been out on the road a lot over the past couple of weeks presenting to clients of the firm around the country with some of my colleagues, which has been brilliant fun and a change of pace. These events however always include a Q&A section where we have been asked our predictions for any number of future events (commodity prices, direction of interest rates, path for inflation etc.). While all of us naturally have an opinion, it is really important to be intellectually honest with ourselves and recognise that a lot of things are unknown and unknowable. It will make us all better investors.
Have a great week – if you have time to read anything over the next few days, make it this.