On the difficulty of forecasting

Investing in equities requires optimism, because the present value of listed companies is based on their future cash flows. An equity investor invests in future success, not in past achievements. Investors need to have confidence that the economy and society will stay on track so that companies can make sustainable profits. 

The challenge is that change in particular is extremely difficult to predict reliably. In practice, most predictions go totally awry.

Yet every day we read market forecasts about "where the market will go next". Experts with convincing arguments are nice to listen to, because they bring a sense of control to a seemingly chaotic world. The more drastic the predictions, the more sensational headlines the media will make of them.

By definition, the future should be difficult to predict. If investors were good fortune tellers, we would be foreseeing everything that's to come. To predict the future, you need to know future technological developments. And if we were to know technological evolution, we would know virtually all the inventions of the future today.

In my videos, I often like to show viewers the market's expectations for future central bank rate moves. As you can see from the chart, expectations tend to be systematically wrong. The central bank itself does not know where interest rates will head in the future. The economy is too complex a social entity to predict reliably. Yet investors rely on these forecasts because for many, it is too distressing to think that no one really knows where the economy is going.

 
Consider the COVID-19 pandemic. The pandemic itself was not a "Black Swan" because it was not entirely unexpected. There had long been warnings about the possibility of a pandemic in a globalized world with varying standards of hygiene. News from Wuhan and infections around the world came as early as December 2019. But for the stock market, the impact of the pandemic finally came out of the woodwork when entire countries were put on lockdown after mid-February. In practice, no one could have predicted such a thing happening in 2020.

And just a couple of years ago, very few people were excited about artificial intelligence.

One more example. The depression of the 1930s is one of the worst known depressions in world economic history, pushing the world toward protectionism and conflicts that eventually became World War II. Economist Robert Shiller has asked economic historians whether they have been able to name a single person who predicted the recession. They have not. The roaring '20s ended abruptly with the worst recession in modern history.

As investment author and blogger Morgan Housel has noted, “We are very good at predicting the future, except for the surprises—which tend to be all that matter.” Indeed, it's easy to say that, on average, the world's standard of living is likely to rise, and so will corporate performance along with overall economic growth. But we don't yet know what the most significant changes will be over the next decade.

As the columnist Carl Richards has well put it, "Risk is what's left over after you think you've thought of everything".

If the future is frighteningly unpredictable, should all your money be in banks' fixed-term deposits, which are (in the light of current knowledge) generally considered safe?

There are many ways in which an equity investor can try to deal with uncertainty. While investing in stocks requires faith in the future, there is no need to be overly enthusiastic about future expectations placed on companies' earnings growth. Having a margin of safety means not paying a fortune for shares. In practice, an investor may opt for shares when they are available at a cheap valuation.

Investors can also favor slow-moving, profitable industries. For example, utilities and basic industry are well-known areas where it is difficult to create shareholder value. In contrast, strong brands in slowly changing fields have a reasonable chance of doing well for years to come. On the other hand, the most profitable sectors are in software, technology, and biotechnology, where predicting company-specific relevance over the long term is always uncertain.

As the old saying goes, “a bird in the hand is worth two in the bush.” Pursuing more birds (bigger profits) in the bush may not be worth it if you already have a surefire winner from a stable industry in your hand. And you also have to consider the time value of money. High-risk, high-potential "long shot" stocks may not pan out if you can get a better return on your money more reliably elsewhere.

A sufficiently diversified portfolio is almost a free lunch. Concentrated portfolios tend to significantly underperform stock market indices because it is so difficult to spot a super performer. Diversification also prevents the entire portfolio from crashing if risks materialize.

Future crises cannot be predicted, but they can be prepared for. Cash is a "free option" to buy stocks later, as Warren Buffett has phrased it. Cash can be used to buy discounted stocks in even the worst market turmoil, as other investors flee the scene.

The most important thing for an investor is time in the market, so that the compound interest effect can really kick in. To ensure this, your portfolio should always be in a position where even the worst market downturn will not kill the whole game.