Beware of placing too much faith in market forecasts

• As financial markets are rocked by the effects of the Russia-Ukraine conflict, it is little wonder that more investors are turning to market forecasts for a sense of what to do next
• Commodity markets have felt the brunt of the impact from the conflict. If the energy crisis deepens, it could hinder the economic recovery
• While people often place much faith in forecasts, they have their own limitations. When forecasters make judgements, biases usually creep in that can affect the results. In addition, making decisions based on forecasts may lead to over-trading assets
• In seeking more reassurance from expert views at times of great uncertainty, considering potential likely scenarios, instead of one absolute view, may be a better strategy. When investing is particularly tough, diversification should make it easier to stay invested and reap the benefits of time in the market
• For those looking to capitalise on periods of uncertainty, and volatility, one possible avenue to consider are products structured to profit from volatility, without needing to taking a directional view

As financial markets are rocked by the effects of the unfortunate battle between Russia and Ukraine, it is little surprise that economists are rushing to downgrade growth forecasts. Similarly, many investors are turning to market forecasts to make sense of events and decide what to do next, in this fog of uncertainty.

The outlook for commodities, and oil in particular, is focusing investors’ minds. Energy prices have surged in recent weeks, as fears of a supply shock grew.  If the energy crisis deepens, it could hinder the economic recovery or even trigger recession. However, the global economy appears more resilient to oil supply shocks now, than it was back in the 1970s.

Forecasts have limitations

Forecasting uses historical data to help predict the direction of future trends. By simplifying a problem, forecasting helps us make sense of the world and make decisions.

A limitation of a model is that it is built on a finite set of parameters, while reality consists of an unlimited number of risks. As such, all forecasts carry a degree of uncertainty.

However, people like to have narratives to help them understand what is going on in the world, and forecasts can help to provide this. That said, in making judgements, and taking decisions, biases usually creep in. For example:

• Representativeness – when assessing how likely an event is a decision may be assessed based on how similar it is to an existing mental prototype
• Availability – events and data points that are more readily recalled may be overweighed
• Overconfidence – people’s confidence in their judgments is typically more than the objective accuracy of those judgments

Changing investment behaviours

In addition to forecasts' inherent biases, there are also biases in how forecasts are used. For instance, confirmation bias can cause investors to pay more attention to predictions that coincide with their world views, than those that run contrary to them.

Making decisions based on forecasts may lead to short-termism when investing, which often results in over-trading assets.  

For those that want views, market-implied probabilities, or the weights that the market assigns to an event based on the current prices of assets, can help to understand what the market’s aggregate forecast is for certain events.

Keep portfolios diversified

In seeking more reassurance from expert views at times of great uncertainty, it may be better to consider potential likely scenarios, instead of one absolute view.

Scenario planning and positioning for several potential outcomes may lead to a more diversified portfolio. A portfolio of quality assets diversified across asset classes, regions, and sectors can help to protect wealth, when reality differs from expectations. And when investing is particularly tough, diversification should make it easier to stay invested and reap the benefits of time in the market.

Having an investment philosophy is key

Being aware of trends that might shape markets and portfolios for decades is important. However, it is unlikely to be in an investor’s long-term interests to shift their portfolio every time an event emerges that they believe may affect markets.

Building a robust investment process that helps to get the balance right between long-term thinking and more opportunistic short-term tweaks to portfolio weightings, can help boost portfolio returns. For those looking to capitalise on periods of uncertainty, it may be worth considering products structured to profit from volatility, without needing to take a directional view on the market.

As episodes of exceptional volatility occur, more opportunities for active managers to capitalise on may occur. By also keeping an eye on investments and investment conditions, portfolio risk can be managed. Extra opportunities to lift the risk-return profile can also be captured, creating the best of both worlds.