There is a pub that I often pass by in my car which hosts psychic fairs. Whenever I see their advertisement along the side of the road, I feel repelled by the nonsense of it all. Why would anyone believe that the future can be predicted?
But this false notion of forecasting is a folly in which economists are constantly engaged. Some make it their business to predict changes in long term interest rates, the next move in the stock market, or whether there is about to be a recession. And yet we have very good explanations for why these are all more-or-less completely unforecastable.
In a recent work, Prakash Loungani, an IMF economist, looked at the record of professional forecasters in predicting recessions over the period 2008-2012 (Ahir and Loungani 2014). There were a total of 88 recessions over this period, where a recession is defined as a year in which real GDP fell on a year-over-year basis in a given country. The study states that “None of the 62 recessions in 2008-09 was predicted as the previous year was drawing to a close. However, once the full realisation of the magnitude and breadth of the Great Recession became known, forecasters did predict by September 2009 that eight countries would be in recession in 2010, which turned out to be the right call in three of these cases.” Loungani concludes that “the ability of forecasters to predict turning points appears limited.”
Proper economists – those that are not wasting their time soothsaying and rune-reading – are coming to the understanding of why recessions are not forecastable. It is because one cannot simply consider the macroeconomic influences such as interest rates and public spending. The real driver is the behaviour of individual companies and their connections of influence.
The catalyst of the 2008 recession was RBS’s collapse. Its failure was tightly interlinked to tens of thousands of non-financial companies which relied on its credit. But it is not just the obvious connections like banking. Natural disasters, like the earthquake in Fukushima in 2011, affected car manufacturing in factories around the world. More positively, IT sector breakthroughs have enabled countless other manufacturing businesses.
Regardless of the column inches devoted to market forecasting, we simply do not know the precise structure of the networks between companies sufficiently enough to accurately predict booms and slumps. The economy is a complex system and as such it is inherently unpredictable.
Still, there are headline grabbing predictions that can seem believable – but beware. The recent armageddon-like predictions from Crispin Odey about a catastrophic global crisis have been made many times before. Odey has made a fortune for his company by betting on shares falling – a process known as ‘shorting’ the market. In 2005, he shorted shares in former building society Bradford & Bingley, which later became a victim of the financial crisis. However, he has not always called markets correctly and early in his career suffered losses when the US Federal Reserve raised interest rates in 1994. He will be hoping to make money if his predictions come true, so it is in his own interest – and that of his investors – to talk down markets.
What should we do to protect our wealth from the unpredictability of the future?
Diversification of investments across both markets and assets is the best defence against uncertainty. Having a portfolio of asset classes whose returns do not exhibit the same patterns when combined together in a portfolio produce what in industry jargon is referred to as an ‘imperfect correlation’, meaning their risk factors cancel each other out.
Combining two asset classes together whose return patterns are entirely independent of one another can reduce the risk of that portfolio by a quarter. A diversified portfolio is formed from assets that are not naturally related to the same influences and therefore will fluctuates at different rates. Since we understand that markets are complex and the real driver of change is relational, diversification offers the best protection against failures and delivers the best possible return over the long term.
I was reminded recently of a bet that Warren Buffet made in 2008 with Protégé Partners. Buffet has staked $1M that a humble index tracker will produce better returns than their complex hedge fund over ten years. With only three years left, he is winning with a 63.5% gain against the hedge funds 20%. It would take a severe equity correction to put his peers back in contention – maybe Odey has a stake in the wager?
There are some forecasts, however, that are worth making in relation to your financial planning – those over which you have a degree of influence. For instance, when you plan to retire and how much money you will need to meet your future financial commitments. Sensible judgements like these are key to forming an effective financial plan.
Contact us to learn more about how we can help you to plan for the future.
Read more about the need for diversification in our blogs: When Markets Get a Cold and Diversification is Not Rocket Science.
This article does not constitute financial advice. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner to take into account your particular investment objectives, financial situation and individual needs. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections.