Wither forecast

Berkshire Hathaway chairman Warren Buffett said: “Forecasts may tell you a great deal about the forecaster, they tell you nothing about the future.”

There is something about the start of a new year that encourages otherwise sensible people to make predictions about the year ahead. In the investment industry, predictions are given for the level of stockmarkets, interest rates, GDP growth rates and foreign exchange rates to name a few.

The historic inability to predict any of these factors with any consistent degree of accuracy does not dissuade these “seers” from trying each year. Looking back at some of the predictions made last year, the most noticeable and frequent predictions were for a continuation of the recovery that most economies were then enjoying. Consequently, most of the prognosticators expected 2011 to be a year of recovery, with growth accelerating through the year, leading to an especially robust final quarter.

Having re-read a number of these forecasts from January 2011, I have not found one that predicted the severity of the euro crisis, the Arab spring or that the US would see its credit rating downgraded.

This lack of success should not be a surprise. Human psychology involves heuristics – these are basically short cuts that the brain uses to process information in an efficient way to prevent us from suffering information overload (though many of us may feel we suffer this anyway). However, these short cuts often prevent us from correctly processing and interpreting information.

Two particular traits encourage us to make (and believe) erroneous forecasts. These traits are known as anchoring and overconfidence (perhaps particularly common in financial markets).

Anchoring is the tendency of individuals to stay close to a piece of factual information, whether relevant or not. For example, forecasts for the S&P 500 index for the end of 2012 are typically based off the current level so there is anchoring around the current level in forecasts. As a result, forecasters are very good at telling you what has just happened.

Overconfidence should need no explanation but, put simply, this is where people are surprised more often than they expect to be.

Unfortunately, “experts” tend to be most prone to overconfidence as the illusion of knowledge encourages it. Studies have demonstrated that armed with more information, experts are far more likely to make erroneous predictions and also have more confidence in their predictions than laypeople.

Given the demonstrable failure of these forecasts to successfully predict anything useful, why do they bother?

Instead of making worthless predictions, time would be better spent considering the present situation and what that implies for the future, what events could occur, how likely such events are and what the implications are for investment of each possible outcome.

Furthermore, this should be a continual process looking out over a suitable timeframe which in most cases is not an arbitrary 365 days (or 366 in 2012).

Such an analysis should then operate in conjunction with a consideration of what to do about the opportunities and risks identified – buy, hedge, sell? For investors, this final part involves focusing on individual companies and then analysing and valuing these companies.

At Veritas, we continually consider the environment in which we are investing and express this through our use of themes.

These themes are then used to both identify potential investments for further analysis that will benefit from the environment we envisage and also to help us skew the portfolio to such beneficiaries (when available at attractive valuations). Our themes help us to deal with the likely environment we envisage and assess some of the risks and identify companies that are protected against these.

Andy Headley is a fund manager of the Veritas global focus fund