Formidable Forecasting for Finance Forecasters in 2018
Forecasting is dangerous business; was once said by many a wise philosopher a long time ago. The start of a new calendar year is usually accompanied by; forecasts, resolutions and grand plans for the next twelve months.
Whilst many commentators might say the latter two points are mostly benign, the former is potentially one of the more challenging and worrisome concepts in economics and finance. One expects the average CEO at a time like this to spew out fighting talk like; “we must fight this year, we must work hard this year and we certainly must win this year! Our forecasts and budgets must be met and realized”. That’s great Mrs. CEO but here is a bucket of iced water for you; at the end of the calendar year, three possibilities could ensue; falling short of the forecasts, exceeding the forecasts or meeting the forecasts.
Even worse news for management, in a paper published in 2010 by Hutton, Lee and Shu, they found that external forecasters, i.e. equity research analysts outperformed the management teams of various companies when they reviewed the forecasting accuracy for over three thousand US firms. The outperformance of external forecasters was more accurate when there was stability in macroeconomic variables in the economy within a period. Should we throw away forecasts and budgets in totality considering some of the evidence available?
When I think about forecasting in finance, two famous sayings come to mind and have different bearings on how one could deal with forecasts. First, Edmund Burke was reported as saying “You can never plan the future by the past” and secondly, Frank Herbert put it slightly differently; “The future remains uncertain and so it should, for it is the canvas upon which we paint our desires”.
It is important to note that both individuals were not economists or finance professionals. This point should however not discount the importance of the wisdom raised in their witty little points. If you don’t fancy knowledge or wisdom from these fine gentlemen, perhaps Mr. known Unknowns, Nassim Taleb might seem more credible on this matter. He has given us memorable nuggets like the “Black Swan” and “Fooled by Randomness”. The summary of both books being forecasting is prone to significant errors because we use the past to forecast the future and therein lies a major part of the problem.
For students of statistics, they are familiar with the concept of the bell curve and to be more fancy about it, a gaussian distribution. The gaussian distribution stipulates defined boundaries within which normal and extreme events are likely to occur. To illustrate, when we buy a ceramic coffee mug, we expect that the bulk of the time when we pick it up to use, it’ll not slip and fall to pieces. The mug falling out of our hands whilst drinking a cup of epic brew is effectively an extreme event that should rarely happen.
Whilst it is seemingly fine to forecast the probability of a rare event like a falling mug, it seems it is more difficult to apply it to the economy and business as evidenced by the abysmal performance of various management teams in the study referenced above. The reported forecasting accuracy was less than 50%. We can’t dispose of forecasts because of Frank Herbert’s expression; management teams, economists and finance professionals need a medium to express their desires of an unknown set of outcomes both near and further into the future.
If the need for expression is important perhaps this need should be modified to take Taleb’s view into consideration. The forecasts should come with wider expected standard deviations. But hold on young man, are you saying that rather than forecasting a profit of two billion naira, I should forecast two billion naira with the possibility of five hundred million naira at the end of the year? The long answer is; well whilst we would try to strive to achieve a two billion naira in profit, there remains the possibility that factors well beyond our control could cause this forecast to go to five hundred million naira. We call this risk management in financial speak.
But Sir, doesn’t this render forecasts less meaningful for performance monitoring processes? The short answer is No! Why? Forecasts serve as a medium to communicate to the various important stakeholders in the review and usage of these numbers concerning an entity. Rather than viewing forecasts as key goal posts for your team or organization, it may be wise to see the forecast as a road map to higher profitability and improved performance in organisations.
Whilst you tidy up on your 2018 forecasts, do remember a formidable forecast might as well be a mirage. To make a forecast meaningful and useful to the desired audience, focus should be placed on the simple and key drivers of the business or variable. Do you sell pens for a living? How many boxes of pens are achievable in sales this year? Working up from there will get you more meaningful results than a more complicated approach.
This article was written by Oladayo Oduwole. You can reach him via oladayo@cefmr.com