Overrated predictions in a world of black swans

Overrated predictions in a world of black swans
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First Published: Thu, Nov 06 2008. 11 29 PM IST

Updated: Thu, Nov 06 2008. 11 29 PM IST
Nassim Taleb in his best-selling book The Black Swan makes the point that the power of prediction is overrated. Taleb questions the 21st century’s obsessive dependence on professional experts in many predictive disciplines even when faced with a record of inaccuracy. After some study, he concludes, somewhat uncharitably, that the views of economists, financial forecasters, stockbrokers, psychologists, college admissions officers, political scientists and others of that ilk have little predictive value.
Over the past 12 months, markets for commodities, bonds and equities have fluctuated violently, providing intuitive support for Talebs iconoclastic views. Thousands of people make a living by tracking these markets and delivering lectures on how markets are expected to work. Reports generated by these individuals are relied upon by mutual funds, individual investors and treasurers in companies when they make critical decisions that impact crores of rupees of assets. Despite this level of focus, the last decade has witnessed significant decline in the markets for technology, housing and financial services, all of which were missed by the experts. It would, therefore, seem that Taleb has evidence on his politically incorrect side.
Why, though, is the predictive power in the financial and economic sphere so low when so much depends on them being right? Delivering the Nobel lecture in economics in 1974, F.A. Hayek, had suggested that the inappropriate use of techniques better suited to the physical sciences in the sphere of economics was one reason for erroneous causal relationships. It is also true that many of the economic indicators being tracked (such as capacity utilization) were defined in the 1940s and have little relevance in a world based on globalization and services. Most importantly, the financial markets today are so complex that it is not possible for any single institution to put together the true picture of the various forces that drive change in the markets. As if to support this thesis, we see that six weeks after the fall of Lehman Brothers Holdings Inc., counterparty banks have relatively little idea of the position they are in, despite a probe into Lehman’s finances under the aegis of the US government.
To set matters right, individuals and institutions, which are better at making these predictions, need to be identified. This can be done by measuring financial analysts using similar benchmarks that they frequently use to measure the performance of those who run the real economy. In the real sector of the economy, if a company were to miss a budget by 30%, its chief executive would be excoriated by investors. Perhaps, as a consequence, firms miss their guidance far less frequently than analysts miss their predictions. When there is such a high bar for accuracy for those who actually run businesses, it should be possible to apply a similar yardstick to those who make financial predictions. In contrast, as is often the case today, firms and media persist in providing credibility to individuals and institutions whose opinions and accuracy are suspect. This does not serve the general interest and needs to change.
For a start, it is important for any published prediction to be accompanied by a system, which compares that institution’s predictions for a 24-36 month period with the reality. Though some magazines do publish analyst ratings, these suffer from several limitations. They identify the best analysts, but rarely comment on the larger mass who are at the middle of the heap, but still manage to publish their views. Furthermore, such rankings tend to cover the last 12 months, a period typically too short to be able to make meaningful judgements. Finally, almost never does one see an explicit comparison of prediction versus reality. The onus for raising the bar and demanding this level of accuracy should lie with the largest customers of these research reports, namely, institutional investors and companies, which invest other people’s money based on these reports.
The democratization of investment in the last decade means that the financial media is perhaps the most important channel through which opinions are created. As retail investors attribute considerable credence to what they read or hear on media, particularly when these views are those of independent analysts, we need to see greater discrimination, among the media, in the choice of who gets heard.
The public makes investment decisions based on the views of these analysts so there is a moral imperative on analysts to set a higher bar for accuracy, not dissimilar to the responsibilities placed on senior management when they provide forward looking statements. This is all the more important as investments required for economic growth depend on the visibility in the markets provided by these experts. Therefore, given the critical role played by these forecasters in ensuring the information flow essential for the prevalence of an efficient market, there needs to be a greater visibility on distinguishing the true performers in this profession from the pretenders. Hopefully, the volatility of the past few months will provide customers of such experts the ammunition with which to demand greater accountability and encourage the media, too, to distinguish the experts from the quacks. None will benefit more from reinforcing the credibility of financial analysts than the analysts themselves.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes on issues related to governance. The views expressed in this column are personal.
Write to him at ruleofthumb@livemint.com
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First Published: Thu, Nov 06 2008. 11 29 PM IST