Fool’s Errand? Predicting the World Cup winners, and the market
05 July 2018
Many of us have been gripped by the 2018 World Cup fever, which has already seen its fair share of surprises and upsets. Current cup holders Germany didn’t make it through the group stages, and other powerhouses such as Spain, Argentina and Portugal followed shortly in the knockout rounds. Following Germany’s exit, an interesting article started making its rounds amongst the investment and sports communities. In May, international private bank UBS had issued a 17-page report titled ‘Football and Investing in Emerging Markets’. The bank predicted that, after running 10,000 simulations, the likely winners of the quadrennial tournament would be Germany, Spain or Brazil. As of the latest score – scratch 2 out of the 3!
If you delve deeper into the individual match predictions, you would notice that many of them did not come true. In the “Five Games to Watch” table, the bank got only 1 prediction correct.
How did UBS carry out their forecasting? A footnote in their report states, “We’ve applied the insights and tools from our daily work as investment strategists to predict the likelihood of each team doing in the tournament.”
The takeaway here isn’t that you shouldn’t rely on a bank to help you with your football bets. The fact that they made these failed predictions with the same sophisticated algorithms they use to make their investment calls should instead give you pause. But is that surprising? Sports, like investments, are nearly always impossible to predict. There are just too many random variables that could affect the final outcome. What if the star player became injured at the last minute? What if the goalkeeper was off-form for a decisive match?
It is the same in the investment world, if not more so. Just when you think you know what’s going on, OPEC suddenly decides to cut oil output. What happens, then? Or if Trump suddenly starts tweeting about starting a trade war with his long-term allies; how does the market react? What if the US Federal Reserve decides to carry out 2 rate hikes this year instead of 4? The permutations of such possible (and highly impactful) scenarios are endless! Which positions should you take, and why?
Whenever we hear a stock analyst give a convincing argument with his well-thought out analysis as to why certain stocks will move up or down, we should take note that academic research has shown that basing investment decisions on forecasts to try to outperform in the long run does not work. Even for strategies which could add incremental value, the additional alpha (or outperformance) is reduced to zero from all the increased trading costs that such strategies incur. UBS likewise warns investors, “Not all our calls are accurate. But by following a systematic investment process, we aim to maximize the number of correct calls and their magnitude”. So, what they are saying is that they will try to make the right calls with the money you invest with them, but they could also lose your money with the wrong calls. Which, to be fair, is the consequence of investing based on forecasts.
What about expert judgement, especially from those highly-qualified individuals and rocket scientists whose job is to study the market and build accurate prediction models? A great book on expert forecasting abilities is titled “Expert Political Judgement” by Philip Tetlock. In it, the writer wrote about why experts are quite often wrong in their forecasts. A lot of the discussion in the book centred on our behavioural fallacies and cognitive shortcomings, e.g. our tendency to focus on the wrong message, and how we are quick to jump to conclusions from circumstantial evidence (something which affects the experts even more).
Tetlock listed five ways our preconceptions shape how we try to estimate the future:
- Experts can talk themselves into believing they can do things they cannot.
There are diminishing returns to knowledge in the prediction game, but overconfidence often trumps this fact. - Experts are reluctant to admit when they are wrong and change their minds.
This is our cognitive dissonance on display. - Experts fall prey to the hindsight bias.
People convince themselves they “knew it all along” even when completely unpredictable events occur (or they just plain missed it). - Experts fall prey to confirmation bias.
Experts have a hard time viewing the other side of an argument. - We’re all pattern-seeking creatures.
We look for structure or consistency where none often exists in the real world, which is quite random most of the time.
Tetlock also found that when predictions do not go our way, there are also a list of excuses which we (and the experts) make in order to cover our shortcomings:
- The “if only” clause: If only this one thing would have gone my way I would have been right.
- The “ceteris paribus” clause: Something completely unexpected happened so it’s not my fault.
- The “it almost occurred” clause: It didn’t happen, but I was close.
- The “don’t hold it against me” clause: It’s just one prediction.
- The “just wait” clause: I’m not wrong, I’m just early.
We aren’t totally against forecasting or predictions. In fact, it’s sometimes fun to try and guess the outcome of something uncertain, e.g. predicting the winners of the World Cup match over beer. Even when we place small bets on our expected winner, we do it in a spirit of fun, knowing that winning is never a certainty.
But to wager our life savings on that same guess is a different matter altogether. Even UBS gives a caveat emptor in their report: “Not all of our predictions will be right. Some games are hard to call and others will simply end with a big surprise.” (Why bother forecasting, in that case?) Then, it becomes high stakes gambling with serious consequences if we get it wrong. But isn’t this what we do when we likewise invest large sums of our hard-earned money based purely on what our banker or investment strategists say is going to happen? Are we having fun, or are we gambling? And can you tell the difference?
Investing is serious business. Most people don’t invest for the fun of it, as the possibility of a big loss can adversely affect them. Therefore, one should always tread carefully and investigate everything that’s being pitched. Investing according to ‘educated guesses’ of what the hot stocks or markets are should likewise be taken with a huge pinch of salt, as one knows full well that absolutely no one can predict the future.
Is there a better way, then? Why not invest in a global index-based portfolio comprising several thousand stocks, and let the market give you the long term return over time? To do otherwise may just be a fool’s errand, like betting on predictions on who will win the World Cup.
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