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Right as rain? - Unlike many financial forecasters, the Met Office accepts the future is uncertain

03/05/2013

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Criticising weather forecasters may be a national pastime in Britain but not on the value perspective. That might come as a surprise to regular visitors, who will have seen our less than favourable opinions of financial forecasters espoused in article such as target practice, but we see important differences between those who predict the economic or market weather and those who focus on the real thing.

An interesting illustration of this can be seen in the met office’s forecasts last year regarding what turned out to be the wettest April on record. At the end of March 2012, the Met office’s three-month outlook stated: “the forecast for average UK rainfall slightly favours drier than average conditions for April-May-June, and slightly favours April being the driest of the three months.”

Another Met office statement later admitted: “given that April was the wettest since detailed records began in 1910 and the April-May-June quarter was also the wettest, this advice was not helpful.” That may be something of an understatement and yet you could wait a very long time indeed before seeing even that level of contrition displayed after a similarly wayward financial prediction.

A key difference between the two branches of forecasting is that while, as we often point out on the value perspective, predicting the future is extremely difficult, at least the weather forecasters acknowledge their limitations in this respect. They never say anything with 100% certainty, instead offering what the academics call ‘well-calibrated’ ranges and probabilities.

What the met office actually said last year was the probability April-May-June would fall into the driest of five categories was 20% to 25% while the probability it would fall into the wettest was 10% to15%. Since there are only five categories, the average probability is 20%, meaning 20% to 25% is only slightly above average while 10% to 15% is only slightly below average.

We have a lot of sympathy for this ‘range of probabilities’ approach because the future is of course uncertain. Risk in financial markets might be defined as the idea that, while many things could happen, only one thing actually does. Understanding risk means understanding all the different probabilities that could occur and good investors never do the portfolio equivalent of ‘betting everything on red’.

Just because last April’s weather did not actually turn out along the lines of the stated probabilities did not make the met office’s forecast a bad one and of course it never said anything would happen with a 100% degree of confidence. Yet in the financial world it is seen as perfectly acceptable practice to predict something will happen with complete certainty.

It would be a rare economist, for example, who claimed there was an x% chance of UK GDP being in one range and a y% chance of it being in another. Almost always it is a single figure and indeed we have quoted before the 19th century us novelist William Gilmore Simms, who observed: “I believe economists put decimal points in their forecasts to show they have a sense of humour.”

Here on the value perspective we prefer to adopt a more nuanced approach – for example, “history suggests very strongly that, perhaps 60 times out of 100, a company’s balance sheet and valuation will see you right” – but let’s return to the weather to make the point more bluntly.

When the met office suggested April 2012 could be slightly drier than average, not even its greatest fans would have resolved to give away their raincoats, bin their umbrellas and spend the whole month wearing t-shirts – and neither should investors construct a portfolio the success of which depends solely on a single eventuality coming to pass.

The Met office has a pretty reliable way of auditing the accuracy of its forecasts – by looking out the window – and it estimates on average its advice is helpful about 65% of the time. This seems likely to be a significantly better ‘hit’ rate than most financial forecasters can boast and investors would do well to remember that when looking to put together a portfolio that can thrive whatever the weather.

 

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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