Forecasting is a critical ingredient to any investment. Readers will know that our job is to “buy a dollar for fifty cents”. Now, observing the market price of fifty cents is easy – we need only look at the share price of the particular stock we are considering to buy. The hard part is knowing that the intrinsic value of that fifty cents is actually one dollar.
Estimating the numerical intrinsic value of a stock involves detailed valuation analysis. Included in this analysis are one’s forecasts into the future with respect to key value drivers of the business. For example: future revenue growth, profit margins, capital requirements, tax rates, etcetera. The larger the error in one’s forecasts of these value drivers, the larger the error in one’s assessment of the intrinsic value of the business.
So what makes one better or worse at forecasting? Well this question has been studied by academics and the conclusions are rather interesting.
For example, a common mistake in forecasting relates to the tendency to focus on the first answer that comes to mind. All humans suffer from anchoring bias and, therefore, tend to become anchored on their first idea and fail to properly consider all alternatives. This mistake can be corrected rather easily, however, through a process that ensures all possible explanations are considered carefully prior to making a decision.
Perhaps even more interesting is the research into personal traits of individuals and the extent to which these impact one’s ability to forecast accurately. For example, some evidence indicates that men are more overconfident in their estimates than women. Here, overconfidence refers to the difference between the individual’s perceived accuracy and their true accuracy.
Some other interesting correlations (though not necessarily causations):
- Extraversion correlates negatively with accuracy on cognitive and estimation tasks;
- Overconfidence has been linked to proactiveness, narcissism and optimism;
- Those who are more reflective and take more time to reason before deciding tend to deliver more accurate outcomes;
- Types of people who typically enjoy effortful cognitive tasks tend to show high accuracy of judgment;
- People who exhibit “grit” – meaning perseverance and passion for long term goals and the ability to overcome adversity – accounted for some of the variance in successful outcomes; and
- Maximizing behaviour, characterized by those who are seeking to maximize every outcome every step of the way, has interestingly been found to result in greater overconfidence and lower accuracy.
In a 2013 academic paper titled: “The role of actively open-minded thinking in information acquisition, accuracy and calibration”, the authors show that Actively Open-minded Thinking (AOT) – a technique developed in the 1990s – predicted greater performance in forecasting. According to the paper:
- “This style of thinking includes the tendency to weigh new evidence against a favored belief, to spend sufficient time on a problem before giving up, and to consider carefully the opinions of others in forming one’s own.”
We pay attention to literature of this nature here at Montaka. We are always seeking to improve our forecasting process and techniques. By improving the accuracy of our forecasts, we can enhance investor returns and reduce investor risk.
Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.