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10 months ago

Blue Chip Issue 82

  • Text
  • Financial
  • Advisors
  • Investments
  • Equity
  • Wealth
  • Offshore
  • Asset
  • Portfolio
  • Investing
  • Global
  • Momentum
Welcome to our Investing Offshore Special Edition of Blue Chip. a quarterly journal for the financial planning industry and the official publication of the Financial Planning Institute of Southern Africa NPC (FPI). Blue Chip publishes contributions from FPI and other leading industry figures, covering all aspects of the financial planning industry.

ECONOMIC FORECASTING

ECONOMIC FORECASTING There is a difference between forecasting and developing a view of the future. But why are we so bad at forecasting? Economic forecasting is difficult for two reasons. Firstly, as shown above, we have been obsessed with trying to predict the future for thousands of years, but it is a virtually impossible task to get right. Secondly, economies are complex. With so many moving parts, it is difficult to know what information is relevant and what is just noise. There tend to be three factors that generally result in poor forecasts which we detail below: Historical data. Economic models describe how an economy fits together through a series of equations and these equations depend on historical data. For example, to form a forecast of the unemployment rate in a year’s time, you need to know what the unemployment rate is today and probably what the unemployment rate has been over a few years. However, if the economy has changed substantially, those historical estimates may not be relevant. This makes it difficult to forecast from the past. Psychology. Like all people, forecasters have inherent psychological biases. Some of these biases include the tendency to look for evidence that confirms what is thought to be correct, anchoring to certain beliefs too strongly and assuming that the current state of affairs in the world will not change. As a result, psychological biases make for bad forecasts, because these biases are not grounded in logic. Complexity. As previously mentioned, the business of developing economic forecasts is tricky not only because it involves making judgements about the future but because markets and economies are incredibly complex. To account for this, economic models are often as complex and easy to misunderstand. A combination of these three factors makes the business of forecasting incredibly difficult, and yet we are still reliant on economic forecasts to form investment views. In fact, to this day economic forecasts form an integral part of the portfolio management process. Reliance on forecasts Given the track record of economic forecasting blunders through time it is easy to assume that the entire process of making economic forecasts is futile. But this tends to be a crude assessment. For example, central bankers use a variety of different economic models that forecast the future path of inflation in an economy so that they can set monetary policy 38 www.bluechipdigital.co.za

ECONOMIC FORECASTING accordingly. Without those models, they would still need to make a call on the future level of inflation in an economy so they can set interest rates accordingly. Using the models here helps make those decisions. Similarly, forecasts are used extensively by investment analysts and portfolio managers for two reasons. Firstly, they help analysts form expectations about sectors, industries and markets which ultimately lend themselves to the portfolio construction process. Secondly, they are used to estimate valuations of specific securities including equities, fixed income and alternative assets. For example, a fundamental equity portfolio manager may develop a model that forecasts the profitability of a certain Rather than using forecasts to foresee future events, we need to accept that, as investors, we will never be rid of uncertainty. company over time. Without making use of forecasting, equity portfolio managers would be hard-pressed to determine which stocks to buy and sell in their portfolios because they don’t have an estimate of how profitable those companies are likely to be. Forecasts are used to develop future market and assetspecific expectations. As a result, trying to do either of these things without making use of predictions becomes an extremely difficult task. This leaves us in a somewhat awkward position. On the one hand we are saying that forecasting is a futile exercise because it tends to be wrong. And on the other hand, we are saying that forecasting forms an integral part of the portfolio management process. So, where’s the sweet spot? Or more specifically, how do managers use forecasts responsibly to construct portfolios? As a preamble, it is important to note that there is a difference between trying to forecast the future and accepting markets as they are today. For instance, portfolio managers that use valuations are trying to understand a number of factors. These include the robustness of a company’s balance sheet; how much market share the business can gain going forward and how consistent dividend payments will be. Developing robust forecasts helps portfolio managers gauge these very important factors that aid in differentiating good investments from bad ones. Forecasts – use responsibly The first thing to accept is that global markets are fraught with uncertainty. And, this is difficult, virtually impossible, to escape. Rather than using forecasts to foresee future events we need to accept that as investors we will never be rid of uncertainty. This leads to an interesting conclusion – there is a difference between forecasting and developing a view of the future. By accepting this axiom there are certain precautions we can take when using forecasts that help us avoid anchoring to certain views or narrowly positioning a portfolio for a predetermined outcome. Firstly, it is important to exercise humility when using forecasts to develop market expectations. It is impossible to know everything and the chances of being wrong are substantial. This can, at times, be the reason that many funds we look at rate negatively, simply because managers overestimate their ability to forecast accurately. Secondly, not everything needs to be a forecast. That is, it is often not necessary to develop explicit forecasts either because they will have an invariable effect on the value of a portfolio or because they are just irrelevant. Knowing which markets, asset classes or industries you need to develop a future view on helps in determining which kinds of forecasts to pay attention to. Thirdly, it is important to understand and accept where your area of expertise lies. For example, when constructing a multi-fund portfolio, a large portion of the forecasting task is essentially delegated to the underlying managers. And this makes sense – the managers are closer to specifics related to the securities they invest in. Lastly, the primary mitigator of forecasting errors is diversification. It pays to be exposed to a broad range of views and not bound to a narrow set of forecasts. Allocating to managers that see the world differently helps mitigate against the uncertainty of the future. Ultimately, humanity has been forecasting for a while and getting it wrong more than we get it right. However, we are still reliant on forecasts because they help us sort through and rationalise a complex trove of information. It is understandable that the uncertainty associated with markets is often difficult to stomach. In addition, it is even more difficult to commit capital to a wide range of assets and not be in control of that capital. However, there are processes that can be put in place to alleviate this uncertainty. These include picking financial advisors that do not overreact to short-term news and diversify across a range of different asset classes as well as finding portfolio managers that are keenly aware of their forecasting inability. A combination of these two factors aids in fostering more certainty in an uncertain world. Matthew Molyneux, Investment Analyst, Fundhouse www.bluechipdigital.co.za 39

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