Forecasting share performance

Forecasting share performance    Written March 23

In a previous article on my website entitled ‘Taking  Advice’ I suggested it’s a good idea to avail yourself of available financial advice – especially if it’s free. If it costs you nothing and gives you additional information – why not? At the same time I cautioned you not to act on any advice you receive from others without first putting it through the ‘grist of the mill of your mind’. I believe everyone should be in control of their own financial destiny with shares and not rely on others, no matter whether they are qualified financial advisors, share specialists or unqualified others such as your friend or hairdresser.

I would now like to expand on this theme and look more closely at forecasting as it applies to shares.

What is a forecast?

A forecast is a prediction about the future. The word ‘prediction’ implies that a forecast isn’t just a guess and isn’t just based on random chance or luck (as is the case with many forms of gambling). For example if I toss a coin I can guess whether it will come down heads or tails. This is a guess because either of the two possible outcomes is equally likely and there is no possible way I can tell which result is most likely. So I can’t forecast the outcome from the toss of a coin, I can only guess it.

Note:

Some gamblers do believe that the probabilities can change even with events where the result is always based on luck. For example if a coin is tossed repeatedly and there are 5 heads in a row, most gamblers will bet on tails on the next toss believing it to be the more likely result. This is called the ‘gamblers fallacy’ and it’s false reasoning (if the coin is a fair one) because the probabilities don’t change regardless of the outcome of previous events.

What is the basis for a forecast?

If the forecast isn’t just a guess it must be based on some information. The only information that is truly available is past info and by using this info a forecast can be made. The forecast is usually made on the assumption that the past provides a guide to the future. With some events this is a good assumption; for example astronomers can predict the path of planets and planetary events with great accuracy. More often using past events to predict the future is far less reliable. For example, on the racetrack, the odds assigned to each horse is based on its past performance. With a race such as the Melbourne cup there’s a huge amount of information about the past performance of each horse and jockey but applying this to the future isn’t at all reliable. Statistics show that the favourite wins the race only about 21% of the time, so predicting the winner based on past performance is highly inaccurate.

Note:

A descriptive way of thinking about this is to imagine you’re driving a car with the all the windows blackened out except the rear window, so the only info you receive is past info. In some cases this will help you, for example if you’re negotiating a long straight road, but in other cases the rear view will be far less useful, for example if you’re driving along a road full of bends. This is more the situation with the sharemarket, as prices seldom move in long straight line but usually fluctuate considerably.

When can a forecast be reliable?

With a reliable forecast two conditions apply:

1. Past info on which the forecast is based is accurate and complete.
2. Future behaviour follows a predictable pattern.

In the case of planetary events both conditions apply – the positions and movement of planetary bodies is very well known and their behaviour is based purely on the laws of physics which are accurately predictable.  In the case of a horse race neither condition applies as past behaviour of horses and humans isn’t fully known and their future behaviour is by no means predictable because it depends on unknown factors such as weather conditions and the physical and mental well being of both horse and jockey at the time of the race (and indeed all the other horses and jockeys in the race).  

What about shares?

Share price performance depends on heaps of factors which can be broadly classified into four types:

• The Australian economy in general as well as other economies – especially the larger ones.
• Specific factors applying to the business in question.
• Investor and trader psychology.
• Customer moods and preferences.

These factors don’t comply with the two requirements for a reliable forecast. Although there can be quite a lot of info available about a company and its products, this info cannot possibly be complete as there’s a whole lot of ‘insider information’ that’s not accessible. Furthermore the behaviour of investors and traders is basically unpredictable.  As I point out in my books, human behaviour is usually driven by instincts such as the herd instinct or FOMO (fear of missing out) or FOL (fear of loss) and these instincts are often irrationally based. So in fact, share prices aren’t driven by actual performance but rather investor’s perceptions of future performance and investor’s perceptions are unpredictable.

Should I take heed of forecasts with shares?

At this point you may wonder why investors often seek (and often act on) forecasts and financial advice. A main reason is that most humans dislike uncertainty and want to eliminate it as much as possible.  Some share investors know very little about shares and lack confidence so prefer to let a more knowledgeable person take care of their investment decisions. But these people are in the minority and the majority of investors simply want some guidance and help to minimise the uncertainty. For example, if you’ve been thinking about XYZ shares and you read a forecast advising that these shares are likely to be a good investment, you feel more confident about buying them. The forecast acts to reinforce your original belief and make you more certain. On the other hand if you read an adverse forecast about these shares, you’re more likely to defer or abort your original idea of buying them because now there’s greater uncertainty in your mind.

There’s no certainty with anything going forward but with your share investments your aim is to swing the odds in your favour. In other words instead of blind luck (as in the case of tossing a coin) you want to swing the odds from 50:50 to more like 60:40 or better. And forecasts can help do that. Historical analysis shows that forecasts about share and share market performance tend to be more reliable in the longer term. So the best approach is not to use forecasts to try and make short term profits from share trading. A medium to long term approach using forecasts to provide some guidance is by far the most reliable way of making shares a good investment.