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Views from the Prairie

June 11

Why predictions fail?

Now that Harold Camping's prediction of the end of the world has come and gone, it can help to look at why so many predictions are wrong. Businesses constantly are predicting the future (with sales and profit forecasts) and almost always are wrong. Why is that?

Most predictions are based on extending a trend. We see that in most business forecasts - the prediction only extends the existing trend as management sees that trend. That means that the prediction can not tell when the trend will stop, the bubble will burst, or another trend will come in and overwhelm that first trend, or, even more importantly, if the trend follows a different distribution than expected.

On December 19, Meredith Whitney made a prediction of 50 to 100 municipal bond defaults with billions of dollars going bad with a time line of 12 months. That sparked a major rush of money out of bond mutual funds. Now, she says that the time line for this might be 5 to 10 years and that the "defaults" will occur in different ways including cities and states cutting services to balance their budgets.

Ms Whitney's prediction is an extreme example of extrapolating from a trend. She saw that municipals were spending more than what they were likely to be able to raise in current taxes. She did not foresee that when the municipals faced the budget problem, they would change their behavior and cut services and raise taxes.

The problem with predicting anything outside of our control is precisely that: we don't have control over what other people, nations, nature, or even the Deity might do. Harold Camping thought that he had a special insight and was proven wrong. Little kids claiming that "my dad will beat up your dad" have about as much insight into the future. In war, experienced generals know that no battle strategy survives contact with the enemy. Things happen that were never in our plans.

In any competitive environment, we have to expect that what we understand as our market can and will change because of what other people do.

A recent stock market analyst pointed to the failure of a once common technique of stock price prediction. At one time, people pointed to the 200 day moving average. When the stock price crossed that moving average, most times that was a solid predictive indicator. However, over the last 20 years, that using the indicator as a trading strategy has produced below average results. It turns out that when everyone knows about a stock price indicator, it no longer works.

The same thing happens in most human activities. When "everyone" believes something to be true, then is when the opposite will happen. This is why "contrarian" investors can make so much money.

The only solid prediction is that changes will happen.

Doomsday Predictions Wrong

Between Harold Camping and Meredith Whitney, our civilization was supposed to collapse. Human history is full of people who have made "doomsday predictions" and repeatedly, they are wrong. It can be easy to see that something bad will happen, but it is almost impossible to tell when that will happen.

For example, the natural scientists are finding out all sorts of information about past major disasters. Between the New Madrid earthquakes, the monster tsunami that is supposed to hit New York City, and the Yellowstone volcano, civilization on the North American continent is doomed. However, these events can be hundreds to thousands of years in the future.

The same problem occurs in the stock market. People can see that a stock is way over priced and can "short sell" betting that the price will go down. One of the few people who made money off of the recent financial crisis was selling short on those CDO's several years ahead of the melt down. But he could not see when the price drop would happen and endured years of criticism by his investors before he made his profits. That time lag between seeing the problem and experiencing the price drop is why "short sellers" rarely make the same level of profits that those who buy and hold do.

What can we do? We can follow trends. We can watch closely to see when a bubble might be happening and make sure that we get out of it before it bursts. We can design business practices and systems that can handle unplanned events rather than trying to protect against all ills.

Misuse of Online Games

Many a spouse complains about the time being spent on the online games and virtual worlds. However, in some places, after a day of hard labor, prisoners are forced to spend hours in online games to run up scores and points which then can be sold for profit by the prison guards. It is claimed that this virtual value can generate more money than the hard labor.


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