Leithner & Co Pty Ltd - Ten-Point Investment Philosophy: Principle 2: Don't Try to Predict 'The Economy'- and Ignore Those Who Do

Principle 2: Don’t Try to Predict ‘The Economy’ –
and Ignore Those Who Do

Graham-style value investors pay little attention to forecasts about the future state of ‘the economy,’ the level and direction of interest rates, inflation, the exchange rate of the Australian dollar vis-à-vis other currencies, unemployment and the balance of payments.

This is because economists’ ability to forecast these things, despite their undoubted diligence and intelligence, is at best tenuous. And even if they could forecast accurately, their activities would distract rather than inform. Hence value investors devote little time to economic predictions. In Mr Buffett’s words, “if Fed Chairman Alan Greenspan were to whisper to me what his monetary policy was going to be over the next two years, it wouldn’t change one thing I do.” William Sherden reviewed leading research about the accuracy of economic forecasts conducted since the 1970s. He found that

economists cannot predict turning points in the economy; their ability to forecast accurately is, on average, neither better nor worse than guessing; increased sophistication (i.e., more powerful computers, more complicated econometric models and greater amounts of data) does not improve the accuracy of forecasts; there is no evidence that forecasters’ skill has increased since the 1970s (if anything, their skill, such as it is, has deteriorated over time); ‘consensus’ forecasts (i.e., the combination of individual forecasts into a single, ‘average’ forecast) are no more accurate than the individual forecasts which comprise them; the further into the future that economists attempt to forecast, the less accurate their forecasts become;
there are no individual forecasters who are consistently more accurate than their peers

Given these disconcerting results, Graham-style value investors keep firmly in mind two seemingly-flippant but nonetheless very important laws of economics. The first is that, for every economist, there is an equal and opposite economist. The second law is that both are likely to be wrong. In the words of influential investor Philip Fisher: “I believe that the economics which deals with forecasting business trends may be considered to be about as far along as was the science of chemistry during the Middle Ages. The amount of mental effort the financial community puts into this constant attempt to guess the economic future makes one wonder what might have been accomplished if only a fraction of such mental effort had been applied to something with a better chance of proving useful.” A more detailed discussion and analysis of these points is set out in a circular to shareholders entitled Why Value Investors Discount Expert Predictions.

Humans’ (including value investors’) inability to foresee economic events and developments with any useful degree of accuracy means that they should discount or ignore analysts, economists or others who claim that they have a clear crystal ball. It does not, however, mean that value investors ignore the future per se. Quite the contrary: they plan for the future not by making particular predictions about what will happen but by considering general scenarios – and particularly pessimistic scenarios – of what might conceivably happen. They then structure their actions and investments in order to reduce the risk of permanent loss of capital in the event that undesirable events and developments actually occur. In this context it is significant that, according to Prof. Terrance Odean of the University of California-Davis, “psychologists have found that people who are mildly depressed tend to have the most realistic outlook” (quoted in The Wall Street Journal 22 September 1998).