How to prevent noise of forecasting from damaging client portfolios

Rajendra Kalur

It’s that time of the year again. A lot of time is devoured in media on predicting how the year is going to be. It’s well understood if these are largely crystal ball gazing by the soothsayers, astrologers and fortune tellers. While this may well be the case, there are also a lot of research analysts, economists and investment managers who indulge in this.

While John Kenneth Galbraith might have said half in jest that “God Invented Economic Forecasting to make Astrologers look good”, there is a fair bit of research available why predicting the future is an activity riddled with flaws.

The peril of forecasting was pointed out way back in 6^th century B.C. by the Chinese Philosopher Lao Tzu who said “those who have knowledge don’t predict and those who predict don’t have knowledge”. Despite this there is a fairly widespread belief that markets can be predicted and timed and an expert in financial markets is one who can predict the course of the markets.

This belief of course has been fostered by the acceptance that the market movements can be predicted based on accurate forecast of cash flows and then discounting back to the present. However, despite the seeming simplicity of this statement, forecasting cash flows by itself is based on several assumptions and at many times may be guess work at best.

In more recent times, several forecasters have been taken by surprise by the stunning recovery of the global economy and continued buoyancy of the stock market for almost 9 years in US. At the beginning of the quantitative easing, several economists had warned about high inflation. This is yet to manifest itself even after several years post the GFC.  There are enough illustrations like these which prove that forecasting is mostly inaccurate.

Acclaimed behavioural economist James Montier, in his book, The Little Book of Behavioural Economics writes that most economists have failed to predict the last 4 recessions even when we are in the midst of them. Similarly, analysts’ predictions on earnings 2 years prior have gone wrong about 94 percent of the time. While this data relates to US, even in India the number of revisions to the earnings forecast proves how difficult it is.

A couple of years back many Oil analysts were predicting a dooms day for oil prices. Today, the facts tell us a different story. At the beginning of the year, many “experts” predicted yet another great year for Indian stock market. Post February 1, the same “experts” might have changed expectations of the future.

Despite there being ample data on the futility of forecasting, there still exists a large demand for such activity and it is only natural that media and the profession cater to this.

However, as someone belonging to the investment fraternity we should desist from the malaise of forecasting and advise a client on a broad base of scenarios. As an Investment Advisor our role in preventing a client from succumbing to the “noise” of forecasters is extremely critical and we can do this if we manage our client portfolios through the following tools:

1. A well constructed risk profiler
2. A goal based financial planner
3. A documented Investment Policy Statement.

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