- Many investors continue to make decisions as if they or the oracles they consult can reliably predict the future, including surrounding presidential elections and their consequences.
- Bets on the U.S. steel industry ahead of the 2016 election worked briefly, but since then every major U.S. steel stock not only has underperformed but is in fact lower than it was on January 1, 2017.
- We seek to eliminate the false precision of point predictions, instead trying to think about the risks and rewards of each investment under a range of potential outcomes.
Human beings long for someone to tell them what will happen in the future, presumably so they can avoid potential negative events. As long as we have existed, we have consulted all manner of sources, from seers and saints to tea leaves and Ouija boards, to try to discover the future. The ancient Greeks were fascinated both with knowing the future — e.g., through consulting the Delphic Oracle — and with ruminating on the conundrum that learning your fate doesn’t mean you can avoid it, however hard you try. King Laius tried to dispose of his child, Oedipus, after he learned from the Oracle that his child would kill him, only to have Oedipus live and murder him years later quite by accident.
Some may debate whether the Greeks believed fate was pre-ordained, which would mean you can’t change your future. A more thoughtful interpretation may be that they believed we can’t know what will result in the future from actions we take now. We may think we can stop a future murder by banishing a child from the city, but that may be exactly what leads to him becoming the murderer. The relationship between an action now and an outcome in the future is not deterministic.
Which brings us to our modern day Tiresiases: economists and political pundits. These experts earn their livings offering investors and others their view of what is likely to happen in the future and what we should do accordingly. Because people don’t find it satisfying to hear waffling predictions — the purview of the infamous “three-handed economist” — these predictions usually are stated with confidence. “Of course interest rates will rise over the next year,” we heard regularly a year ago. The 10-year U.S. Treasury note yield has fallen by almost 50% since the end of the third quarter 2018. Now it’s “Of course the Federal Reserve will cut rates multiple times in the next year and long rates will fall.”
"The relationship between an action now and an outcome in the future is not deterministic."
But forecasting is incredibly difficult. In his stellar 2005 book, Expert Political Judgment, Philip Tetlock presented the results of decades of research into the accuracy of experts’ forecasting on a broad range of subjects. The result, David Epstein wrote in a recent article in The Atlantic, was, “The experts were, by and large, horrific forecasters. Their areas of specialty, years of experience, and (for some) access to classified information made no difference. They were bad at short-term forecasting and bad at long-term forecasting. They were bad at forecasting in every domain. When experts declared that future events were impossible or nearly impossible, 15 percent of them occurred nonetheless. When they declared events to be a sure thing, more than one-quarter of them failed to transpire.” One would think that Tetlock’s work would have helped reduce the market’s fascination with single-point, definitive predictions of events across most subjects. However, that does not seem to be the case. Many investors continue to make decisions as if they or the oracles they consult can reliably predict the future.
We instead prefer to consider what may happen in the future as broadly as we possibly can and then proceed to understand the impact of the value of each investment we make under those scenarios. One of the behavioral biases that we seek to avoid is confirmation bias, which tends to be quite common among those that have a stated view of “what will happen.” If you don’t take a view on what will happen, you can interpret new information from a more objective perspective. We seek to eliminate the false precision of point predictions, instead trying to think about the risks and rewards of each investment under a range of potential outcomes. To be clear, we do not advocate going into the future blind. We just choose not to try to predict it. As we get new information, we can update our ranges as objectively as possible.
Remember, Tetlock’s study was simply about predicting the future accurately. That’s just the first step. The second, equally challenging step is to make a successful investment decision based on that prediction. Take, for example, the 2020 U.S. presidential election. We’re already seeing a growing number of predictions from Wall Street pundits about what investors should do if they “believe” a certain candidate will be nominated or win the presidency (Exhibit 1). As we learned during the debate over the Affordable Care Act when Democrats had control of Congress and the White House — as well as the Republicans’ attempt to overturn it when they had control of both branches of government — making significant changes to U.S. health care policy is extremely difficult. It is also far from clear which entities would benefit and which would be hurt by the changes. For example, the ACA ended up having much less of a deleterious effect on managed care companies than many assumed even after passage.
Exhibit 1: Managed Care Stocks Versus Expectations of Policy Change
The Hot and Cold Steel Trade
Consider: What would investors have done three years ago, on the eve of the 2016 presidential election if they knew for sure what the outcome was going to be? Based on campaign promises, Mr. Trump was viewed as an ally of the steel industry, and in fact he did follow through on some promises, such as imposing tariffs on steel imported into the U.S. So, if one knew the outcome of that election ahead of time, one would reasonably buy U.S. steel stocks, right? For a period of two months that would have been a profitable investment (Exhibit 2). However, since then every major U.S. steel stock not only has underperformed but is in fact lower (a range of -15.8% to -78.3%, as of September 30, 2019) than it was on January 1, 2017 (Exhibit 3).
Exhibit 2: Steel Stocks Rose After 2016 Election
Financial markets and global economies are extremely complex and adaptive. We choose to focus on the areas we believe we can add value and produce long-term risk-adjusted returns for our investors. We cannot add value through superior knowledge of the future and the ramifications of that knowledge. We don’t think anyone can over time (without some legally sketchy behavior). What we focus on instead is understanding the economics of each investment candidate we consider and what they would be worth under a wide range of scenarios. We assess the market’s forecast as well, what the current price implies about future scenarios, and invest when we think the odds are in our favor. This leads to a better understanding of the risks we take and why, which allows us to update our understanding with new information and change course when we’re losing our edge. We then seek to understand how risks from each stock aggregate in our overall portfolio, so that we don’t concentrate our risks in certain future scenarios. In sum, we would rather be approximately right than precisely wrong.
Exhibit 3: Steel Subsequently Upended High Expectations