Monday, October 13th 2014
Every once in a while, the financial media gets enamored with catch phrases that subsequently become hop topics and most current risk factors for the market. After a while, but not before extracting its toll on asset prices, these flash in pan risk factors disappear from collective memory.As i write this note, the most recent one being last weeks IMFs warning about downside risk to Global economic growth forecast for CY'14. And its subsequent toll on world equity and commodity prices.
Now, I have been following IMF Global Economic Outlook reports for some time, and one thing that I can tell about these reports is: That they are usually a medium term extrapolation of what is current ground reality. Secondly, IMF is a specialist in listing all possible risk factors on the horizon and then caliberating the mood in its quarterly reports based on the importance it gives to some of these risk factors. That methodology makes IMF reports good source on analysis of the current environment but lends little credibility in correctly predicting future course of action. (Now, is that not true of all analyst, well including myself!).
The real reason why market participants react to IMF warnings is mainly emotional, and can be explained with what behavioral economist like to call 'availability bias' and for some it is simply trying to pre-empt the rest by reacting (even blindly) to the reports' headline! As the inertia gathers momentum, the warnings actually turn out to be self-fulfilling prophecies. In that context, IMF would rather be serving the global community a service by not publishing any reports at all. But for that to happen, the ivy tower economist at IMF and such other institution have to accept that they may not have any durable edge versus the rest of the us in predicting future. And in most cases, the fact the future cannot be predicted. Current predictions are little more than approximation of the current collective emotional state of mind and status quo. With that belief, I set out to do some googling and came across and interesting paper "The seer-sucker theory -value of experts in forecasting" by J Scott Armstrong published in 1980. In a nutshell the paper concludes and I quote 1) No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers. 2) Expertise beyond a minimal threshold is of little value in predicting more accurately
I could immediately identify with the conclusions of that research paper. It also helped me outline a investment philosophy that I would eventually want to internalize and implement in taking investment decisions. That philosophy is
1) Future forecast are unreliable and/or of little practical value, except when these forecast (no matter how poor) can gather enough publicity to nudge public opinion in its direction (a clear example of the same being: controversy over climate change)
2) If future forecasting is of little relevance, on what premise/framework should investment decision be taken? In my view, if one believes in the above research findings, investment decisions should be based on
a) current misallocation (eg. Japanese 10 yr JGBs yielding 0.6%) where the current situation is extreme to past history or reasonable expectation about future. Or where current data and projections implied in current price about the future are out of sync with one another (example the valuation of India listed cos. called Justdial)
b) When arguments justifying current valuations are largely based on complex future multi year forecasts
c) Special situations which are not properly understood by market participants or entail significant emotional control that average market participant is unable to have
d) investment decision that require only simple logical scenario modelling and conclusions which are readily intuitive and acceptable (eg; Warren Buffets reasoning of buying a farmland in '86 based on simple assumption about yield and crop prices)
3) Ability to accept disconfirming evidence and not get overly committed to our own prior beliefs (guarding against self-confirming bias)
Although the philosophy is well articulated above, the real challenge is to stick by it in thick and thin. Some of the above suggestions require significant psychological and emotional strength. And it is very challenging to remain true to the philosophy when managing external capital or working under an organizational setup where the investment philosophy is starkly different.
(all feedback welcome)
Siraj Presswala, CFA
San Diego, Monday, 13th Oct 2014.