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14. The most important thing is to know what we don't know. We have two types of people: those who make predictions and those who don't know, and those who don't know that they don't know. It's frightening to imagine that we don't know something, but even more frightening is to imagine that, in general, the world is run by people who believe they know exactly what is happening.
There are two types of people who lose money: those who know nothing and those who know everything. I chose only three epigraphs to open this chapter; I could cite a million more similar ones. Being aware of the limits of our knowledge about the future is an essential component of my investment approach.
I am quite convinced that: A) it is difficult to know what the macroeconomic future holds for us, and B) few people have unparalleled knowledge on these subjects that guarantees them some regular advantage in the world of investments. There are two caveats, however: the more we focus on smaller facts, the more we can gain some informational advantage.
With hard work and competence, we can reliably know more than our colleague about specific companies and assets, but this is much less likely to occur in relation to markets and economies. So I suggest that people try to know what is... Regarding a suggestion I made, which will be explained in the next chapter, I believe investors should try to discover, in terms of cycles and pendulums, if they are aligned at a given moment.
This will not allow them to predict the exact timing of future upheavals, but it can prepare them for these probable events. I will not try to prove my claim that the future is known; one cannot prove a negative statement, which certainly includes mine. However, I have not yet met anyone who knows with certainty what is to come in macroeconomic terms.
Among all the strategic economists you follow, there is someone who is right most of the time. My research on this subject—and I use quotation marks because my efforts in the area are too limited and anecdotal to be called serious research— consists mainly of reading forecasts and observing their lack of utility.
I'm using two methods on this: Dev Val of predictions or the all R com from a value of predictions or where all this rain came from. February 15, 1993 and the deval of predictions. Second or "Gives that man a cigar. August 22, 1996. In the second memo, I used data from three semi-annual economic surveys by The Wall Street Journal to examine the usefulness of forecasts.
First, were the forecasts generally accurate? The answer is no, obviously not. On average, the forecasts for the 90-day Treasury bill interest rate, the 30-year bond rate, and the dollar exchange rate for the following 6 and 12 months had an error greater than 15%. The forecast for the long-term bond interest rate 6 months later showed an error of 96 basis points—a divergence large enough to transform the value of a $10,000 bond into $ 10,000.
Second, do forecasts have any value? Forecasts prove very useful when they are able to correctly anticipate changes. If someone predicts that something will not change, and that something actually does not change, it is likely that this type of forecast will not generate much money for the person who made it.
However, accurately predicting changes can be very profitable. In the newspaper's surveys, I noticed that the forecasts failed to predict several changes." Important when accurate forecasts would have helped people make money or avoid losses: the interest rate increases of 1994 and 1996, the rate decline in 1995, and the gigantic revolutions in the dollar exchange rate—in short, there simply wasn't much correlation between the predicted changes and the actual changes.
Thirdly, what was the source of the forecasts? The answer here is simple: most forecasts consisted of extrapolations. On average, the forecasts were up to 5% above or below the levels assessed at the time they were made. Like many forecasters, these economists were driving with their eyes glued to the rearview mirror; thus, they could tell where things had been up to that point, but not where they were going.
This goes back to an old adage: It's difficult to make accurate predictions, especially regarding the future. Its corollary is also true: predicting the past is very easy. Fourthly, were the people making the forecasts ever right? The answer is a strong yes. For example, in the semi-annual forecasts, someone always accurately predicted the yield on 30-year bonds with an error of 10 or 20 basis points, even when interest rates changed.
Radically, this prediction was much more accurate than the Consensus's, whose error ranged between 70 and 130 basis points. In fifth place, if people sometimes got it right so dramatically, then why are we still so negative about predictions? Because when making them, the important thing is not to be right once, but to be right consistently.
The memo I wrote in 1996 continued in this way, and two things can make us think twice before listening to those who made correct predictions: First, they generally failed to make accurate predictions in other surveys, only in the one they got right; and second, in the predictions they didn't get right, at least half of them were much more wrong than the Consensus's predictions.
The most important thing, of course, is not the data but the conclusions, assuming they are correct and can be generalized and their ramifications. One way to be right is to always follow only one trend, whether upward or downward. If we maintain a single view for long enough, sooner or later we end up being right.
And if we only make predictions that are outside the curve, it is possible that we will be applauded for some unconventional prediction that has... Having correctly perceived what no one else has managed to do, but this doesn't mean that these predictions regularly have any value. It's possible to be right about the macroeconomic future occasionally, but not regularly.
It's pointless to have access to a survey of 64 predictions that include some correct ones; you need to know which ones are right. And if the correct predictions are made every six months by different economists, it will be difficult to believe that there is any value in collective predictions. The discussion about predictions suggests a dilemma: the results of investments will be entirely determined by what happens in the future, and although we can know most of the time what would happen when things went normally, we are unable to know what will happen in those moments when this knowledge would make all the difference.
Most of the time, people predict a future very similar to the recent past; they are not necessarily wrong. Most of the time, the future is largely a reprise of the recent past. Based on these two points, it is possible to conclude that predictions will be correct most of the time when they extrapolate recent experience and are accurate.
However, the many predictions that correctly extrapolate past experience have little value. Just like people... Those who make predictions often assume a future very similar to the past; markets do the same and tend to price things assuming the continuity of recent history. Thus, if the future is like the past, it is unlikely that people will make much money, even those who have made an accurate prediction from time to time.
However, the future ends up being very different from the past. It is in these moments that accurate predictions would have great value; it is also in these moments that predictions tend to be incorrect. Some predictions may be correct at these crucial moments, suggesting the possibility of correctly predicting certain essential events, but it is unlikely that the same people had such foresight.
As the discussion consistently suggests, in the end, predictions have very little value. If the reader needs proof, ask yourself how many people correctly predicted the subprime mortgage crisis, the global credit crisis, and the gigantic collapse of 2007-2008. Perhaps you will find some people and conclude that the predictions of these individuals were valuable.
But then ask yourself how many of these few were able to predict the economic recovery that began slowly in 2009 and the enormous market rebound that year. I think the answer is... Very few people correctly predicted the 2007 and 2008 crises. And this is no accident. Those who correctly predicted the 2007 and 2008 crises probably did so, at least in part, because of their pessimistic tendencies.
They likely remained pessimistic about 2009, so the overall usefulness of these predictions wasn't good, even though they correctly anticipated some of the most important financial events of the last 80 years. Therefore, the most important question isn't whether predictions are correct occasionally; the most important question is whether predictions as a whole, or individual predictions from any given person, are consistently useful and valuable.
No one should bet too much on an affirmative answer. In 2007, the prediction of a global crisis would have been extremely valuable. However, would we have taken any action if we had seen that the prediction came from someone without a consistent track record of accuracy, someone with a visible pessimistic bias?
That's the problem when the people making the predictions are inconsistent. Not that they are never right, but the history of their speculations isn't positive enough to inspire confidence and lead us to act. It's no secret that they don't have a very good opinion. Regarding the people who make predictions and those who blindly believe in them, I've given these people a nickname.
Most of the investors I've met over the years belong to the Dua school. I know it's easy to identify them: they believe that to make good investments it's essential to know the future direction of economies, interest rates, markets, and widely followed traditional stocks. They guarantee that it's possible to know all this; they know they can do it; they are aware that many other people are trying to do the same, but they believe that either everyone can win at the same time or only a few can.
They feel comfortable investing based on their own opinions about the future; they really like to share their opinions with others, even though they know that correct predictions are so valuable that nobody would give them away for free. They rarely analyze their predictions to rigorously evaluate their track record of hits and misses.
Confidence is the key word to describe the members of this school. For the Dua school, I don't know; on the other hand, the key word, especially when dealing with the macroeconomic future, is caution. Its adherents generally believe it's impossible to know the future, that they don't need to know what the future holds, and that the most appropriate goal of the investor is to realize...
The best possible job without any prior knowledge of the future as a member of the Dua school. I know people can give their opinions on the future, and maybe others will take notes. You might be sought after for your opinions and considered a desirable dinner guest. Especially when the stock market is rising, join the Dua school.
I don't know, and the results will be more varied. Soon you'll get tired of saying "I don't know" to strangers. After a while, even relatives will stop asking your opinion on market trends. You'll never enjoy that incredible moment when your prediction is correct and the Wall Street Journal publishes your picture.
On the other hand, you 'll be spared all the times your predictions are wrong, as well as the losses that can occur when investing based on an overestimation of the future. Nobody likes investing in the future knowing that the future is largely unknown. On the other hand, if that's the case, it's better to accept the situation and look for another way to deal with the problem that doesn't involve predictions.
It's much better to recognize and accommodate the limitations imposed on us in the world of investing than to deny them and move on. Oh yes, one more thing. The biggest problems tend to arise when investors forget the difference between probability and outcome. That is, when they forget the dual limits of predictions; when they believe that the shape of the probability distribution is known and certain, and that they know this; when they assume that the most probable outcome is what will happen; when they assume that the expected outcome accurately represents the actual outcome; or perhaps most importantly, when they ignore the possibility of improbable outcomes.
Reckless investors who ignore these limitations tend to make mistakes in their portfolios and occasionally suffer enormous losses. This is the story of what happened between 2004 and 2007. Many people overestimated the extent to which outcomes were known and controllable and underestimated the risk present in the things they did.
Knowing whether attempts to predict the future will work or not is not just a matter of mere curiosity or academic reflection. It has, or should have, important consequences regarding investor behavior. When we commit to an activity that involves decisions with consequences for the future, it seems quite obvious to act one way if we believe the future can be predicted and another if we believe it cannot.
A fundamental question that investors need to answer for themselves is: is the future a...? Given known or unknown data, investors who believe they know what the future holds will act assertively and bet in one direction, concentrating their positions, leveraging their holdings, and counting on future growth; that is, they will do things that, in the absence of a forecast, would increase risk.
On the other hand, those who believe they do not know what the future holds will act very differently and diversify, taking on two risks, incurring less debt or none at all, prioritizing present value over future growth, maintaining a healthy capital structure, and generally preparing for a variety of possible outcomes.
The first group of investors fared much better in the years leading up to the crisis, but the second group was better prepared for the crisis, had more capital available, and was psychologically more intact to profit from purchases at very low prices. Those who claim to know the future do not need to play defensively and should therefore behave aggressively and seek the right moves, as they should not fear loss.
Diversification is necessary, and one can employ maximum leverage and debt; in fact, being unduly modest about what one knows can result in opportunity costs and profits that... On the other hand, those who don't know what the future holds shouldn't act as if they do, because that would be reckless.
If we return to Moverk, the powerful quote that opened this chapter, we see that the conclusion is quite clear: investing in an unknown future is a frightening prospect. But if the possibility of prediction is unreliable, investing as if the future were a known fact is madness. Perhaps Market said it best: what gets us into trouble is not the things we don't know, but those that, even if not true, we are certain are true.
Overestimating what we are capable of knowing or doing can be extremely dangerous, whether in a brain operation, a transoceanic race, or making investments. Recognizing the limits of what we are capable of knowing and working within those limits, instead of venturing into uncharted waters, can give us a great advantage.
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