Tuesday, May 09, 2006

The problem with forecasting - a call for scenario thinking

I'm reading a very interesting book relating to risk management, Upside Downside: Simple Rules of Risk Management for the Smart Investor. It's a light read and a rather small book - nevertheless, it has some good ideas.

In the section discussing why investors should lay out different possible scenarios, rather than simply forecasting, it makes the point that forecasts are too often simply the present extrapolated into the future. It uses some rather famous statements by prominent individuals and organizations to make the point:
  • One day, there will be a telephone in every major city in the US - Alexander Graham Bell, circa 1880.
  • There will never be more than 1,000 cars on Europe's roads, "because that is the limit on the number of chauffeurs available" - Daimler Benz spokesman.
  • "Stocks have reached what looks like a permanently high plateau" - Irving Fisher, professor of economics, Yale University, 1929.
  • "I think there is a world market for maybe five computers" - Thomas Watson, chairman, IBM, 1943.
  • "There is no reason that anyone would want a computer in their home" - Ken Olsen, chairman, Digital Equipment, 1977.
  • "... with over 50 foreign cars already on sale here, the Japanese automobile isn't likely to carve out a big slice of the U.S. market" - Business Week, 1979.
  • "640K ought to be enough for anybody" - Bill Gates, Microsoft, 1981
  • "Television won't be able to hold any market it captures after the first six months. People will get tired of staring at a plywood box every night." - Darryl F. Zanuck, 20th Century Fox, 1946.
or how about this one that I recalled ...
  • Oil: Under the heading "Drowning in Oil", The Economist magazine predicted the world - then with $10 a barrel oil, was heading towards $5 a barrel oil - 1999. Today, forecasts here are quite different.
I hope you got a chuckle out of some of these - but as investors, we need to be diligent in thinking about both risks to our investments, but also potential opportunities that can arise - if the future turns out different from the past - i.e. one does not need a chauffeur to pilot an automobile around.

The book points out that laying out the possibility of a number of different scenarios, requires some thinking about the situation, and considering that differences in the future may arise. By laying out a number of different possibilities - some perhaps even seemingly far-fetched, it allows us to better consider the risk/reward potential of an investment.

By doing so, we avoid the blind reliance on the "most likely" forecast, and to therefore protect ourselves to some degree against other, seemingly obscure, possibilities.

Scenario thinking - worth considering in your own investing.


The Confused Capitalist

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