Prediction, Judgement and Forecast

Investing should always run through the three stages of predicting the range of outcomes, judging the probabilities, then melding these into a forecast.

Prediction is laying out the possible nodes of events. Firstly though, the assessment of the current situation is needed. This involves the gathering of data, information and sentiment, then turning this into useful measurements.

Judgement is then employed in assigning probabilities to each node. Often there is history available for similar situations that can be used in deriving a probability distribution. Otherwise, reasonable estimates of the probabilities with accompanying assumptions need to be produced, without ever ignoring the extreme tails.

Forecasting is the combination of the pay-offs from each predicted state and their respective forecasts, weighted and aggregated into a single point estimate. It will not be accurate but at least it will give some ideas as to whether proceeding with the strategy is a rational act or not. Note that the range of predictions has an impact on the discount rate, typically the wider the range, the higher the required rate of return. This is the sentiment part of the equation and the hardest to get right but equally significant.

It is important for investors to know our edge and not be overconfident in all areas. Often it is better to delegate a good part of our judgements to active or passive fund managers and focus on the selective areas where we can reasonably expect to assess the range of outcomes more accurately. In addition, our forecasting is not going to be great, the accuracy of which would be 52% of being right versus 48% of being wrong, but accumulative over time and number of ideas, it does make a difference. For a venture capitalist and right-skewed probabilities, you can have even less than 50% chance of being right and still come out ahead.

Every action and non-action in investing is itself based on the utilisation of prediction, judgement and forecast, whether applied explicitly or merely as a rough guide to structuring your thoughts. Of course, errors can be made at any stage, either with the assumptions, construction or calculations. Updating assumptions, model construction and calculations in light of new information can keep an investor busy. But that is the mechanism of how new information gets integrated into the price and how an efficient market should operate.

No one can know what will happen, but it is reasonable to assume that a sharpened knife can cut, a big dark cloud carries heavy rain or that a horribly run company will fail. Finance, from its discounting models to putting a value on a newly obtained contract, is always about the future. Therefore, anything other than that is not a decision-making process, and certainly not investing, but instead rolling a pair of dice at a casino table and hoping for the best.


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