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A word on forecasting: its wildness lies in wait
2/18/2018 9:04:46 PM
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THE ETF INVESTOR
Investment management insights from a leading Canadian expert.



By Tyler Mordy  | Monday, February 12, 2018


 



In the early months of the new year, our inboxes are bombarded with outlooks for the year ahead. Economists, strategists, and other financial commentators trip over themselves to issue precise forecasts for the next 12 months. Where will the Dow end in 2018? How much growth will Japanese GDP show? Will the market “crash” – and if so, when? And when the market suddenly turns volatile as it did last week – seemingly out of the blue – why didn’t the pundits, experts, and forecasters predict it? Our industry should stop doing this.

Forecasting variables, such as where stock markets will exactly end the year (impossible), what GDP will be (subject to multiple revisions), is an exercise in futility. History shows a horrific track record here.

The issue is that the world is not that perfect. How can we expect our models to offer such precision? As the prolific British writer G. K. Chesterton (known as “the prince of paradox”) observed in 1908:

“The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”

Why then is forecasting such common practice? In short, people crave certainty. This danger lies in the illusion of safety that this false sense of precision creates. Overconfidence results and portfolio mistakes are made.

One of our favorite concepts over the years has been Andrew Lo’s observation that the financial industry suffers from “physics envy.” We want our models to be as predictive as those in physics, but there is a behavioral element to finance that cannot be modelled. Humans can be capricious, and what’s right in one regime will be wrong in the next. As one physicist remarked, “Imagine how much harder physics would be if electrons had feelings!”

Investment implications

Not all is lost. Rather than playing the mug’s game of point-forecasting all these variables, we strongly believe it is the macro themes that matter. Of course, forecasting these super trends (as we call them) is not an exact science. We are looking at a range of possibilities and positioning portfolios for the probable environment ahead. This is one part fundamentals (where we are in the cycle, valuations, etc.) and one part behavioral (where the consensus thinks we are in the cycle, levels of euphoria or complacency, fund flows, etc.).

In the post-crisis environment since 2008, it has been critical to have this type of disciplined process. Ed Yardeni has counted 57 so-called “panic attacks” in this 8.5-year bull market (taper tantrums, Brexit, etc.). At panic points, it is always useful to revisit the role of the portfolio manager: Why do clients pay us to manage their wealth? It is not for flawless clairvoyance. Rather, we are paid to anticipate probable risks, prepare for opportunities and, importantly, not lose our proverbial minds when everyone else has lost theirs. That requires a disciplined decision-making framework that can extract emotion from the process. Forstrong’s investment team remains committed to this approach.

Tyler Mordy, CFA, is President and CIO for Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. He specializes in global investment strategy and ETF trends. This article first appeared in Forstrong’s Gobal Thinking feature. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com . Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.

Notes and Disclaimers

© 2018 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.

The foregoing is for general information purposes only and is the opinion of the writer. The author and clients of Forstrong Global Asset Management may have positions in securities mentioned. Commissions and management fees may be associated with exchange-traded funds. Please read the prospectus before investing. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

 
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