Forecasting biases; anchoring & optimism

The start of the year – while company results are awaited – is forecasting time.  There may not be much fresh information, but analysts re-work their figures nevertheless.  We get index forecasts for the year, new stock price targets and revised assumptions for commodities, currencies and interest rates.  The calendar drives analysts’ output.  Typically, optimism pervades and stocks suddenly look cheap, and investors react predictably.  Reality hits with the arrival of company results in February.

 Last year, the early optimism was followed by much better chances to buy in the next few months.  Research tends to be euphoric at the start of the year; forecasts for the year ahead are not analysts’ strong point.  How can we sift through the avalanche of predictions?

 Behavioural finance highlights how much forecasting tends to be anchored in the present.  Today’s commodity prices and exchange rates are given far greater importance than they merit.  Most economic forecasts move little from the status quo.  And, company research often suffers from over-optimism.  Analysts typically have unrealistic expectations of corporate earnings growth, and this means overall consensus earnings shoot way ahead of reality.  One study, covering the last quarter century of US forecasting, shows that each year corporate earnings growth estimates have typically ranged from 10-12%, but the actual outcome was just 6%.  Only twice, during the earnings recovery following a recession, have forecasts under-estimated actual earnings growth.  And, the record for macro-economic forecasting is no better.

 It is easiest to extrapolate trends and patterns.  Most currently target the FTSE up another 10% or so in 2011, following last year’s trend.  Many even look for a similar pattern over the year; dull initially, but recovering as the year progresses.  Yet, the more complex the predicted sequence of events, the lower the probability.  A detailed scenario of how the year might unfold is simply a story – something experts are good at.  In behavioural terms, it may appear more convincing to flesh out detail in a forecast.  A sequence of events unfolding as the year progresses, is actually less likely, but it will seem plausible if it sounds like a familiar scenario. And, the nearest year we have in mind is 2010.  We should be wary of forecasts that sound too much like last year, or are too similar to today’s market pattern.  What we recognise appeals to us. 

 Experts are at their best when they set out assumptions and outline a range of possibilities, but do not give undue weight to an outlook that simply sounds more plausible.  It is difficult to encompass a full range of possibilities in a single forecast, or even to encapsulate the analyst’s range of knowledge in a single estimate.  Probabilities and risks are not so neatly explained. 

 We should be wary of forecasts that do not recognise uncertainty; experts are prone to overconfidence and their apparent conviction adds little value.  It can be salutary to check last year’s forecasts – now simply done with the aid of internet search.  Behavioural finance tells us that experts are more confident about longer term predictions –the distant future is not actually easier to foretell, but confidence is actually driven by the speed of feedback.  Experts hate being told they are right or wrong within minutes, but love the idea of rather vague twelve months’ feedback.

 Few current forecasts pay much heed to potential surprises.  A trade war between China and the US, turmoil in the Eurozone, or even a changing political landscape, are much harder to factor in.  Resilient portfolios can not simply tilt at the end of year forecast, but must be robust against major risks.  Last year, many investors did not have the patience for a year in which half of the returns came in December.  Others were unnerved by the second quarter sell-off.  Forecasts ahead of results season are a poor basis for investing.  Private investors and fund managers must be psychologically prepared for left field risks. 

This article is for informational purposes only. The opinions in this article are the author’s own. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Colin McLean may have an investment in any of the companies mentioned in this article.

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