The Pitfalls of Forecasting
Reflections #9
Welcome to this week's edition of Reflections. Forecasting is widely used in finance, yet it often leads to significant errors due to common misconceptions about uncertainty. Let's explore three major fallacies in forecasting and how they can impact decision-making. This article is inspired by an excerpt from the book The Black Swan by Nassim Nicholas Taleb.
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Forecasting is often viewed as an essential tool in not only investing, but also business and daily life. Yet, despite its widespread use, forecasts are prone to significant errors that can mislead decision-makers.
Today, we'll break down three critical fallacies that highlight the dangers of forecasting and why relying too heavily on predictions can result in costly missteps. Understanding these misconceptions can help us manage uncertainty better and avoid the overconfidence that often accompanies flawed forecasts.
The First Fallacy: Variability Matters
The first mistake lies in taking a projection too seriously without considering the accuracy of the forecast. It's tempting to look at numbers and predictions and assume their validity, but this mindset leads to misjudgements.
“Don’t cross a river if it’s four feet deep on average.”
If you rely solely on the average, you might find yourself in water over your head. While a forecast might give you a middle-of-the-road expectation, it's crucial to pay attention to the range of potential outcomes and the uncertainty surrounding that average.
Taleb offers an example: imagine planning a trip, and you're told the temperature will be 70 degrees Fahrenheit, but with an error margin of 40 degrees. That wide margin introduces a huge level of uncertainty, and making decisions without accounting for such variability can lead to serious mistakes.
"The policies we need to make decisions on should depend far more on the range of possible outcomes than on the expected final number."
Yet, as pointed out, professionals often ignore this error margin. For instance, in investing, people project future cash flows without taking into account the uncertainty around them. Businesses frequently rely on long-term forecasts, but without acknowledging that these are simply educated guesses and not guarantees. One of the main takeaways from this fallacy is that forecasting, especially for long-term projects, should always include an awareness of variability. Ignoring this can be likened to gambling with more at stake than expected.
The Second Fallacy: Forecast Degradation Over Time
The second fallacy stems from the assumption that forecasts are equally valid whether for short or long periods. As time stretches, the degradation of forecasts becomes apparent. However, humans struggle to appreciate the rapid deterioration of accuracy over time. The further into the future you try to predict, the more unreliable that forecast becomes.
Look at economic predictions for GDP growth, inflation, or stock prices a decade ahead—they rarely hit the mark. This degradation stems from unforeseen events, changes in variables that were initially thought to be stable, and the inherent randomness of the world.
"Forecasting through time becomes evident through simple introspective examination."
When we step back and reflect on predictions from the past, it’s easy to see how wrong we can be. That’s why, for decisions that affect the long-term, we must approach forecasts with scepticism, constantly revaluating them as new information becomes available. The message here is that as the forecast horizon lengthens, the assumptions behind the forecast should be continuously questioned and adjusted. Otherwise, we risk building our decisions on weak foundations.
The Third Fallacy: Misunderstanding Random Variables
The third and perhaps most dangerous fallacy is rooted in the misunderstanding of random variables. Many forecasts and models assume a normal distribution or, at the very least, a stable set of variables that can be predicted. But in reality, the world is filled with "Black Swan" events—those rare but impactful occurrences that no one sees coming.
"These variables can accommodate far more optimistic—or far more pessimistic—scenarios than are currently expected."
This statement gets to the heart of the issue. Random variables are unpredictable and can lead to wild outcomes that lie far outside the realm of typical expectations. When we forecast without considering these rare events, we leave ourselves vulnerable to catastrophic errors.
Humans tend to perform well in stable environments but falter when faced with rare, high-impact events. We have a tendency to model our predictions based on what we have seen in the past, but the future holds surprises. Forecasts that ignore the possibility of extreme events, whether overly optimistic or pessimistic, leave decision-makers blind to the real risks.
In investing, for example, a model might predict moderate stock market returns based on historical data, but a Black Swan event like the 2008 financial crisis can completely invalidate those predictions. Those who had planned their financial future based on moderate predictions found themselves blindsided.
The implication here is that it's not enough to rely on projections that don't account for these outliers. As the Taleb points out:
"Even if you agree with a given forecast, you have to worry about the real possibility of significant divergence from it."
When forecasts seem solid, we must be cautious of unexpected turns. It’s not just the average or most likely outcome that matters—it's the worst-case scenario, the one we least expect, that often has the most profound impact.
Wise Are Those Who Know They Cannot See Far Away
In summary, forecasting is a double-edged sword. On one hand, it’s necessary for planning and decision-making. On the other hand, it can be dangerously misleading if we don’t approach it with the right mindset. The three fallacies outlined in the reading—ignoring variability, underestimating forecast degradation over time, and misunderstanding random variables—reveal the common pitfalls we must avoid.
"Perhaps the wise one is the one who knows that he cannot see things far away."
This humility in the face of uncertainty is the ultimate lesson. While we cannot see the future, we can acknowledge its complexity and build our strategies accordingly. By embracing variability, recognising the limits of long-term forecasts, and preparing for rare but impactful events, we can navigate uncertainty more effectively.
In any field that relies on predictions, understanding these fallacies can mean the difference between success and failure.
The next time you’re faced with a forecast, remember that it’s not just about the numbers—it’s about what lies beneath them, the unseen risks that can change everything.
ICYMI
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Disclaimer: The content provided in this newsletter is for informational purposes only and does not constitute financial, investment, or other professional advice. The opinions expressed here are those of the author and do not necessarily reflect the views of Schwar Capital. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. The author may or may not hold positions in the stocks or other financial instruments mentioned. Always do your own research or consult with a qualified financial advisor before making any investment decisions.
This quote from The Wall Street Journal in 1993 still holds today:
“There are two kinds of forecasters, those who don’t know and those who don’t know they don’t know.”
—John Kenneth Galbraith, Canadian-American Economist (1908-2006)