Wednesday, December 23, 2009

“This or That is Going to Happen”

I have often written about the industry’s insistence on denying that professional investing has anything to do with making forecasts. Making forecasts is all about making market “predictions” and market predictions seem to be no different than selling snake oil to the suckers who will do anything to believe in a cure. Here is what one of our favorite fund managers, John Hussman, has to say about forecasts in his Weekly Market Comment (Clarity and Valuation, Dec 21, 2009):

Probabilities, however, are not certainties. If the probability of a given event is “p”, then the probability of “not that event” is (1-p). This, in my view, is what makes probabilities and average outcomes different from forecasts. When people forecast, they say, “this or that is going to happen,” and very often they establish investment positions that will do them a great deal of harm if they are incorrect…”

There is no doubt that an investor who makes asset allocation decisions based on a forecast that says, “this or that is going to happen,” is taking on a very large risk that his or her forecast could be incorrect. At Pinnacle, our asset allocation is based on our best assessment of the economic and market data as we see it in “real time.” We are all about assessing the risks to our forecasts, if that’s what they are. We want to better understand our level of conviction in our forecasts, because if we have a low conviction forecast we are going to allocate assets closer to our pre-agreed benchmarks for risk that we’ve established with our clients, and we are going to be more diversified in our approach to sectors, countries, industries, etc. As we get closer to being able to say, “this or that is going to happen,” our conviction is higher in our forecast and we can have large deviations from our benchmark and more concentrated positions in the portfolio.

So, Pinnacle makes a different kind of forecast. Instead of saying “this or that is going to happen,” we say, “We have a high or low conviction in the probability of this or that happening.” I guess I’ll stick to my guns and proudly say that our statement about the probabilities of future events occurring still constitutes a forecast, and I will let others deny that they make them at all. Either way, we strongly believe that our approach gets to the heart of the matter, which is that no one can know the future with certainty. Those who invest as though they do should beware.