Evaluating Investment Predictions

Regular readers know that we have a strong interest in predictions -- those based upon models, but also others.

Many investment heroes made a prediction without a time frame. Our guess is that many readers would be surprised at a comparison of results between these forecasters and those who took the opposite viewpoint. But that is a subject for another day.

We also like looking at sports predictions. This takes the investor out of the normal environment. In sports there are many more instances. One gets into "the long run" more quickly.

Briefly put, analyzing predictions from sports helps us to think objectively about economic and investment forecasters.

An Interesting Example

In a recent baseball game, meaningless in the overall standings, one of the announcers for Seattle made a very specific prediction. Take a look at the video.

The initial reaction is --- Wow!

Evaluation

There are two very distinct ways of looking at this prediction. The first is inspired by Fooled by Randomness, a book highly recommended, and one that we sent to many clients.

Taking this approach, we ask how many similar predictions are made each season. Many broadcasting teams (all of them?) have a "pick to click" question. The skeptical analysis would suggest that there were thousands of predictions, mostly inaccurate and ignored.

If a prediction works, then and only then does it get publicity. We have no idea how many similar predictions never saw the light of day.

On the other hand, this particular prediction has a very high level of specificity. The announcer predicted which at bat, what the count would be, that the pitch would be a fastball, that the hitter would connect for a home run, that it would be to left field, and that it would reach the second deck.

This is not just a run-of-the-mill pick to click.

Investment Take

We are interested in comments on this example. It seems dissimilar to most investing predictions because of the specificity.

Most investment gurus follow the key commandment:

Do not make a prediction that has both a target and a time frame!

Comments

[Tom Armistead:]

We have seen some equally good calls in the investment arena, some of them had to do with the purchase of way out of the money puts during the financial meltdown. Others have to do with the purchase way out of the money calls on situations where it develops there is M&A activity in the offing. The expiration date of the options provides a degree of specificity about the timing.

Alas, these good calls seem to have had the benefit of tip offs, or the game was rigged, some type of collusion or insider information. The baseball incident was wonderful, a random prediction that came true, and good for comic relief.

You can get a fair number of pundits who will venture a prediction for the level of the S&P, typically by year-end, some of them will be close, by the law of averages. As a practical matter, any investment decision has a target and a time frame implied, there has to be a minimum return the investor will accept, so on and so forth.

So a target with a time frame can be a useful tool for investment thinking, how else do you pick between alternatives? Of course very few of these guesses will be right on target. A sense of humor helps.

Oct 06 10:31 AM

[Denis Gould:]

One of the most dangerous pastimes in investing is the return forecast - particularly if that return forecast is then fed into some form of "optimiser" for portfolio construction purposes. Think about return forecasts. I can say the market is going up and have a decent chance of being right. If I say the market is going up 10% then my chances of being right diminish substantially. But if I say the market is going up 10% AND will be at that level on the 7th January then clearly my chances of being right are extremely slim indeed. But that is what a return forecast requires - a forecast of a price at a specific point in time.

You might get lucky and look like a genius like your baseball pundit, but most of the time you are going to be plum wrong. Benjamin Graham was clear on this - "Forecasting security prices is not properly part of security analysis". And yet the industry persists in economic forecasts which miss every major recession, earnings foreacsts which get missed despite companies doing their utmost to massage them, and target prices which have an average forecast error in the region of 25%. Don't follow them.

Oct 06 08:38 PM

[Tom Armistead:]

Denis, this is gobbledegook. Anybody who is going to invest in a logically consistent way has to have a target and a time frame in mind. From there you have to monitor new information as it comes in and revise targets as things change.

If nobody knows anything then you are back to the monkies throwing darts.

I am an amateur and when I write up a stock I give a target and a time frame. If I were a professional no doubt I would be more circumspect. lard my articles with weasal words, stand behind the curtain and pull the levers, the wizard of Oz thing.

Likewise when I look at the S&P I have a target and a time frame, these are revised as often as new information comes in.


On Oct 06 08:38 PM Denis Gould wrote:

> One of the most dangerous pastimes in investing is the return forecast
> - particularly if that return forecast is then fed into some form
> of "optimiser" for portfolio construction purposes. Think about return
> forecasts. I can say the market is going up and have a decent chance
> of being right. If I say the market is going up 10% then my chances
> of being right diminish substantially. But if I say the market is
> going up 10% AND will be at that level on the 7th January then clearly
> my chances of being right are extremely slim indeed. But that is
> what a return forecast requires - a forecast of a price at a specific
> point in time.
>
> You might get lucky and look like a genius like your baseball pundit,
> but most of the time you are going to be plum wrong. Benjamin Graham
> was clear on this - "Forecasting security prices is not properly
> part of security analysis". And yet the industry persists in economic
> forecasts which miss every major recession, earnings foreacsts which
> get missed despite companies doing their utmost to massage them,
> and target prices which have an average forecast error in the region
> of 25%. Don't follow them.

Oct 07 11:32 AM

[Jeff Miller:]

Thanks for the comments. I hope it is clear that I am spoofing some of those who make vague predictions with no time frames.

And Tom, thanks for appreciating the effort at getting a smile along the way. The announcer in the video could hardly believe it himself!

Oct 07 07:09 PM