Behavioural finance

Proceed with caution when using market forecasts

04 April 2022

By Alexander Joshi, London UK, Behavioural Finance Specialist

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  • Summary
    • In highly uncertain times, many investors turn to historical data and market forecasts to make sense of the world
    • However, while they have their benefits, they also have their own in-built uncertainties – which you should be mindful of
    • Investors should also be cautious of giving too much weight to any one forecast or piece of data – as it can lead to a more short-term view of investing and excessive trading
    • Instead, you should think through a series of potential scenarios – instead of having just one view. Positioning your portfolio for a range of outcomes will then likely lead to a more diversified portfolio
  • Full article

    In times of uncertainty, investors understandably seek expert views and forecasts to make sense of events. However, people should keep in mind the uncertainty involved in forecasts, and be aware of how using them can influence decision-making.

    There is much going on in the world right now, and uncertainty is high. Making sense of events, their likely results, and potential impact on economies, markets, and portfolios is a tough task. People don’t like uncertainty, and it is understandable that during times like now we seek more clarity.

    As heavy Russian shelling of Ukraine continues despite attempts at peace talks, investors are turning to the outlook for commodities, and particularly the oil price, which has surged in recent weeks. Sharp and sustained increases in the oil price have often led to recessions, especially when driven by supply shocks; so if the energy crisis deepens it could potentially affect the economic recovery. However, the global economy appears more resilient to oil supply shocks today, than it was back in the 1970s and 1980s.

    Forecasts have benefits

    Forecasting uses historical data to help predict the direction of future trends. Assumptions are made and a model is created, which takes inputs to generate predictions.

    Models don’t have to be explicit, they can also be mental models. All investors are consistently forecasting, whether consciously or unconsciously. Even the biggest sceptics of the value of making predictions, inevitably express views about the future when they make an investment decision. By simplifying a problem, forecasting helps us make sense of the world and make decisions.

    But we can’t predict the future

    A limitation of a model is that it is built on a finite set of parameters, while reality affords us infinite sources of risks. We cannot predict the future, and so all forecasts will have a degree of uncertainty.

    However, this doesn’t stop us from trying to do so. Stories help us to understand the world around us, and they may provide a degree of confidence in what might happen. That said, in making judgements and taking decisions in an uncertain world, there are biases that creep in, which can affect how information is processed and forecasts are made. For example:

    • Representativeness. When we’re trying to assess how likely a certain event is; we often make our decision by assessing how similar it is to an existing mental prototype
    • Availability. We overweight events and data points that are more easily recalled in our minds, for instance, dramatic news such as the present conflict
    • Overconfidence. Our subjective confidence in our own judgments is typically greater than the objective accuracy of those judgments

    Investors should be cautious with the weighting given to any one forecast (be that their own, or those made by others) when making investment decisions. This is particularly important for point estimates (such as the predicted level of some commodity prices) without bands of uncertainty around it. The further out a forecast, the larger the confidence intervals around an estimate will be.

    Forecasts can influence investment behaviours

    All forecasts will have some element of bias in them, but there are also biases in how they are used. A model might show some risks, but not the risks of using it.

    The confirmation bias, where extra weight is given to data that confirms pre-existing beliefs and views, can lead investors to place much confidence in particular predictions that coincide with our own world views. Evidence to the contrary gets less attention.

    Making decisions based on forecasts, in particular if they are short-term ones, can also lead to unhelpful investment behaviours. Forecasts may lead to a more short-term approach to investing, and also over-trading of assets, in particular if the forecasts being used are subject to considerable, or frequent, revisions.

    For those who do want views, market-implied probabilities, which are weights that the market is assigning an event, based on current prices of financial instruments, can give an investor an understanding of the market’s aggregate forecast for certain events.

    But ensure portfolios are diversified

    For investors that want the reassurance of views from experts, when faced with considerable uncertainty, it may help to think more about potential scenarios, and the likelihood of them, instead of one absolute view. If we believe that it is possible to forecast markets, it diminishes the perceived need for diversification.

    Thinking through different scenarios and positioning a portfolio for a range of outcomes will likely lead to a more diversified portfolio.

    Whilst an investor may have a strong conviction about the evolution of events and the corresponding direction of markets as a result, a portfolio of quality assets diversified across asset classes, regions, and sectors can help to protect wealth when reality differs from expectations. It can help an investor navigate volatile and unnerving market conditions, and should make it easier to stay invested and reap the benefits of time in the market.

    Having an investment philosophy is key to success

    While we recommend caution, this is not to say that investors should not be thinking about changing conditions and where they can provide opportunities.

    It is important for investors to be aware of trends which may have lasting impacts on markets and their portfolios. One does not want to miss such trends. However, it is unlikely to be in the long-term interests of an investor to tilt their entire portfolio every time an event is identified that they believe may affect markets. Similarly, for attempting to time the market. Such behaviours have often been shown to have a negative impact on investment returns.

    One of the best ways to increase the likelihood of success is to follow a robust investment process, striking the right balance between long-term thinking, to generate the core investment returns, and more opportunistic short-term tweaks to allocations to maximise overall returns. For those looking to capitalise on periods of volatility and uncertainty, one possible avenue to consider involves products structured to profit from volatility, without needing to take a directional view.

    Continued volatility in an uncertain world may dislocate markets, most likely providing opportunities for active managers to capitalise on. By additionally monitoring current investments with the changing economic and market conditions, portfolio risk can be managed. Additional opportunities to enhance the risk-return profile can also be captured, creating the best of both worlds.

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A surge in the price of oil, as well as elevated inflation levels, are making many economists reassess their global growth forecasts. Changes to both can also very easily move financial markets. This month’s articles aim to provide some much-needed context and clarity – at a time when volatility and uncertainty weigh on investors’ minds.