On Forecasting

Think about the famous question of the bat and ball costing £1.10. The bat costs £1 more than the ball. How much does each cost?

The answer, of course, is £1.05 and 5 pence. However, many (including apparently 50% of Harvard undergraduates) come up with the answer of £1.10 and 10 pence. We all know that we shouldn’t jump to conclusions without sufficient thought, but this is exactly what we do most of the time.

January is a good time to think about the effect that jumping to conclusions has on our forecasting capabilities. Many well-known experts make forecasts with great certainty and are consistently believed. The news nowadays also seems to be full of what “will” happen in the future. I find this somewhat frustrating as there is no provable certainty and we must always bear this in mind.

Anybody involved in any type of forecasting, including financial modellers, should read Philip Tetlock’s excellent book, Superforecasting. Tetlock famously said that dart throwing chimps can make better forecasts than groups of experts. However, in this book, he shows how careful analysis, with appropriate use of probabilities and openness to new information, can improve the accuracy of forecasts.

Tetlock does not pretend that we can really predict the future. Many may dispute this and point to certain economists and pollsters who “called” certain events. However, remember that with enough forecasters out there, some may well predict the correct answer. For some healthy scepticism about forecasting, I would also recommend Nassim Taleb’s The Black Swan.

There is so much of relevance for financial modellers in Tetlock's book: he encourages forecasters to be aware of “cognitive bias” (systematic errors in thinking which affect our judgements) and “belief perseverance” (the way we avoid acknowledging new information which upsets our beliefs).

Always remember that no one can ever predict the future absolutely. Those who have been on my financial modelling courses know my views about crystal ball gazing. As one of my recent participants said: "If you gaze at a crystal ball for too long, you will end up with glass in your eye" (and of course with a whole heap of circular references too).

“The only certainty is uncertainty.” Pliny the Elder

“Prediction is very difficult, especially about the future.” Niels Bohr

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