27 July 2021

    The folly of the forecast

    David McLeish

    Head of Fixed Income

    Email David
    David McLeish

    Head of Fixed Income

    Email David

    This article was originally published in the New Zealand Herald on 22 July 2021

    There is something quite romantic about the future. But its mystery can also be deeply discomforting, challenging our need for control. And it is this longing for control that has sparked our love affair with predictions.

    In financial circles, central banks are well known for their predictions, often forecasting interest rates many years into the future. And it is their economic mana that often turns these forecasts into widely accepted statements of fact.

    But as their projection for higher interest rates again become consensus, it’s worthwhile considering the practice and practicalities of prediction.

    Humans are hopeless romantics

    Most of us already know how terrible humans are at prediction. Research suggests this has to do with how much we want the predictions to come true. The more we want something, the more we believe it’s likely to happen. Understandably, this connection is most strong when we predict our own future behaviour. This is because of our tendency for over-optimism and over-confidence in our predicting capabilities.

    Those who know, don’t predict; those who predict, don’t know

    Studies also suggest that ‘experts’ are not much better at prediction than the general public. The forecasting inability of economists have been the subject of numerous studies. But again, we tend to hold what these gurus say in higher regard, without much consideration for their track-record or ulterior motives.

    It is in the murky world of monetary policy where all these dynamics come together in one place.

    Fool me once, shame on you. Fool me twice, shame on me. Fool me thrice, shame on both of us

    In May, the Reserve Bank of New Zealand caused quite a stir when, in their latest Monetary Policy Statement, they projected the Official Cash Rate rising by 1.5% over the next three years.

    They themselves set this overnight interest rate, so again very few question their projections. Therefore the market's response was, dare I say it, predictable. Investors moved quickly to reduce their bond holdings because they know if rising interest rates are coming this will push down the value of fixed income assets like these.

    But I wonder if the reaction would have been different if this latest prediction had been delivered alongside the previous mid-year predictions the Bank has made – which the chart below shows.

    The Reserve Bank modified its approach during the pandemic. So, there was no mid-year Official Cash Rate projection in 2020.

    Be careful when you follow the masses. Sometimes the ‘M’ is silent

    The trouble is not that people make predictions. The trouble is that others blindly follow them without much thought for their likely accuracy or the consequences that come from reacting to them.

    For example, investors who sold their New Zealand bonds and parked the funds on call in the bank when the Reserve Bank made a similar forecast in 2010 would have missed out on around 30% returns between then and now. Similarly, when the Bank began raising interest rates in 2014, some borrowers rushed to lock in their 7%, 4-year mortgage rates — only to see mortgage rates 1% lower just a year later.

    Focus on the short term and look at the facts

    Listening to and considering a wide range of opinions will undoubtedly improve decision-making. But it always pays to add a healthy dose of scepticism.

    Better still, rather than attempting to make accurate long-term predictions, we think you’re better off focusing on the near-term and dealing with facts as often as possible. For example, we have found that an astute assessment of the current economic environment is far more valuable than any forecast when deciding on the right mix of assets to hold in an investment portfolio.

    Knowing what you don’t know is important. But knowing that others don’t know either is just as important. As Mark Twain once famously said, “It ain't what you don't know that gets you into trouble. It's what you know for certain that just ain't so”.