Why you should not try to predict the future when investing

By Dhirendra Kumar

Some time ago, I came across a lesser known gem about investing on the Internet. This is a speech delivered almost 40 years ago by an otherwise forgotten investment manager of a long-gone fund management firm called Batterymarch. The speech has become something of a legend, being passed along on the web as one of the classics of clear thought and fundamentally useful ideas about investing. The title of this speech is “Trying Too Hard”. Surely there’s no such thing as trying too hard? It turns out there is. Google the speech and read the whole thing. One of the most interesting bits is the analogy between physics and investing.

The foundation of Newtonian physics was physical events are governed by physical laws. If we learned enough about the laws, we could extend our knowledge and influence our environment. That was also the foundation of most of the security analysis, technical analysis, economic theory and forecasting methods we learned. There were rational and predictable economic forces. If we tried hard enough. If we learned every detail about a company. If we discovered just the right variables for out forecasting models. Earnings and prices and interest rates should behave in rational and predictable ways. If we tried hard enough.

However, as in physics, the investor’s reality is more like quantum mechanics. The events are not subject to rational behaviour. There is evidence showing our knowledge of what governs financial and economic events isn’t nearly what we thought it would be.

Most equity investors believe if they gather enough knowledge and apply it all, they will know what is going to happen to an investment. All of it adds up to trying to know where stock prices will head tomorrow and make money. We all believe that a research report or an article in the business press has a good chance of predicting the future. But do they? It depends on what you mean by the future. Do you mean the near future financial numbers of well-known companies, or do you mean something that has a bigger impact?

The answer to this question becomes clear when we look into the past and see what was predictable and what was not. Think of what has happened in the last quarter century in the economy and markets. Could any of it be forecast? Think of both big long-term trends as well as short-term ones. In the late 1980s, could you have forecast the astonishing rise of Indian software services? Was the rise in urban Indian living standards predicted? Was the drop in interest rates and the easy money economy predictable in 1995? Was the resultant housing boom predictable?

In 1996, when a cheap, basic mobile phone cost Rs 20,000, did anyone make a correct prediction about how many mobile connections India would have in 2008? Was the near collapse of the global financial system in 2008 foreseen two years before that? In 2009, when the equity markets hailed the return of Manmohan Singh as Prime Minister with a stronger mandate, was the sorry mess of the next five years predictable? Of course, recent events are so firmly a part of this list that it’s pointless to mention them.

Needless to say, there are many experts who can ‘predict’ these events in hindsight. The person will now say the vast pool of English-speaking and technical manpower made the rise of IT and ITES services exports inevitable, and that mobile telephony followed a predictable path in the fall in price of electronic goods.

However, they’re saying this now. The movement of the stock markets have been just as much of a surprise. The direction as well as the sharpness of each bull and bear market of the last two decades has been utterly unpredictable.

So does that mean that investors have no basis on which to try and forecast what direction their investments should take? Not quite. In fact, the lack of predictability means what remains is truly valuable. Which is to judge quality businesses on the basis of long track record, and hold large and diversified portfolios so that negative effects of company and sector specific events can be evened out. In fact, even though they appear to be part of the same spectrum kind of activity, these are two fundamentally different approaches to investing. One is about trying to predict the future. And the other about taking a reasoned look at the present and try and judge what are the things that happened that will stay the course.

(The author is CEO, Value Research)