ADRIAN SAVILLE: A New Year’s resolution for forecasters: stop it

It’s the start of a new year, and with that come resolutions that see us committing to new behaviours to ensure we end the year in better shape. One new year’s resolution that is likely to get investors of all shapes and sizes into better form is to stop forecasting. 

Imagine if, at the start of 2020, you were asked to estimate world economic growth for that year. Or, in 2021, you were asked to forecast the rate of inflation for the US economy for that year. Or at the start of 2022 you were given the opportunity to name the country that would have three prime ministers in two months.

Each is an important investment question as the outcomes have implications for currencies, interest rates, company earnings and asset prices. Knowing the answers a year in advance would give any investor a gigantic advantage.

This is why so many investors devote so much effort to figuring out the answers to questions like these — and the start of the new year is the most-favoured season for this endeavour. Yet again and again the world delivers surprises — and shocks — that show just how hard it is to figure out what tomorrow will look like.

This is how we arrived at a 4.9% contraction in 2000, 7% inflation in 2021, and three prime ministers and four ministers of finance in the UK in 2022.  

At the end of each year John Authers runs a fun exercise that shows just how powerful forecasting could be as an investment tool. In Points of Return Authers reports on the performance of the fictitious investment firm Hindsight Capital. And year after year Hindsight Capital delivers spectacular results because its managers are in command of the one strategy guaranteed to beat all others without fail: hindsight.

In 2022, Hindsight Capital’s managers made some exceptional calls: Vladimir Putin really would invade Ukraine; China’s economy would take strain from the Omicron variant; inflation would not be transitory; and interest rates would hike far quicker and further than expected, putting pressure on security valuations around the world.

With hindsight, shorting Tesla, FTX Token and the ARK Innovation ETF would have delivered gains of 69%, 98% and 68% respectively. And after the returns produced by markets in 2022, most investors would grab these types of results with both hands if Hindsight Capital really existed.

But Authers suggests that identifying names with this type of precision makes the exercise a little unfair. Instead, he proposes that Hindsight Capital be limited to broad themes. With this constraint in place Hindsight Capital’s team bought US defence contractors and went short Ukrainian stocks (+244%); and they also went long the S&P 500 energy sector and short S&P 500 automakers (+354%).

In a contrarian bet on autocrats, they went long Recep Tayyip Erdogan and short Putin by buying Turkish firms and selling Russian equities (+234%). Hindsight Capital also invested in integrated oil and gas firms, which it funded by shorting global wind energy (+101%). As with every other year, seeing backwards delivered fantastic returns for Hindsight Capital.

While it’s a fun exercise, there is a serious undertone to this thought experiment. All of Hindsight Capital’s calls were contrarian, at odds with market consensus. Individually, each of the ideas would have looked foolish based on the mood at the start of 2022, and collectively they might have been regarded as folly, or even lunacy.

This is an important point to make at the start of each year where there is a penchant for identifying the big drivers for the coming year — as if markets are somehow calendarised — and then positioning portfolios accordingly.

While anecdotal, the annual quiz exercise and the Hindsight Capital thought experiment show just how hard it is to peer into the murky distance. And these anecdotes are supported by rafts of empirical evidence that reach across time, asset classes and countries and show that we are bad at forecasting.

Yet the temptation to forecast persists, because the world is complex and we are human. But we are bad at forecasting for the same reasons: the world is complex, and we are human. Put simply, the temptation to forecast is powerful and seductive. But this is a dangerous investment habit, and one that should be broken quicker than any other New Year's resolution.

The Bob Newhart skit in which he acts as therapist Dr Switzer to his patient, Katherine Bigmans, gives us all the guidance we need when it comes to the habit of forecasting. Newhart tells his patient that there are just two words she needs to remember when it comes to changing her behaviour: “Stop it!”

If you want to do your investments a big favour in 2023 here’s the resolution when it comes to forecasting: “Stop it.” This leaves us with the question of what we should do in the place of trying to see around corners. Thankfully, there is an excellent substitute.

With the benefit of hindsight, many of the greatest investors have three permanent features in their portfolios. They own good assets, at good prices, and they diversify to manage risk. And many — not all — add a good dose of patience.

This might mean that at the start of the new year you own some high-quality emerging market equity that looks extremely attractively priced; inflation-linked bonds to deal with not-so-transitory inflation; fewer dollars, which are expensive, and more South Korean won, which look cheap; some physical gold, which is a powerful diversifier; and perhaps TSMC, a shunned Taiwanese semiconductor manufacturing firm trading on 13 times earnings.

And if you’re wondering what the events of 2023 will mean for these investments, stop it. This is a diversified portfolio of good assets, owned at good prices, which gives us the single best investment approach across all times and all markets.

While we wait for foresight to become hindsight, I wish you a wonderful 2023.   

• Dr Saville is investment specialist at Genera Capital.