Tails between our legs

If you work as a research analyst or fund manager, one of the hardest things to learn is how to deal with failed forecasts. If you ask me, dealing with failure the right way is a key factor in becoming a better investor.

More than two decades ago. Philip Tetlock (of Superforcasting fame) analysed how people who made predictions about political events dealt with failure. He found that most of them used excuses to shift blame and he found five strategies used by experts to salvage their reputation in the face of a failed forecast:

1. The ‘if only’ defence: Experts might insist that if some precondition had been met, the forecast would have been correct. This is the ‘real socialism has never been tried’ argument that all evidence to the contrary was due to the inept implementation of sound policies. This is also what you hear a lot these days from the defenders of Liz Truss’ disastrous economic policies in the UK.

2. The use of the ceteris paribus clause: Holding all other things constant, my forecasts would have been right. Shame though that other things never stay constant, and this is why my forecasts were wrong. This is the favourite of economists as demonstrated in their constant use of the phrase ‘ceteris paribus’.

3. Almost: The forecast may have been wrong, but it was almost right except for that unpredictable shock like a banking crisis, pandemic, etc. that derailed everything. Go back to 2020 and read any analyst forecast and you are bound to see this in print.

4. Eventually: The forecast may not have been right so far, but if you wait long enough, it will be true. This was the favourite excuse of monetarists in the decade after the financial crisis when all the money printing created absolutely no inflation whatsoever. This is also a common excuse used by value investors who are still waiting for their undervalued stock to recover.

5. Our framework was right, but the forecast was not: This is the excuse that forecasts are inherently uncertain and individual forecasts should not be taken too seriously. This is the current favourite of Andrew Bailey and Huw Pill at the Bank of England who in every press conference are asked by journalists if they concede they were wrong in their inflation forecasts in 2021 and 2022 just to reply that the confidence bands were unusually wide back then and that this is why their forecasts were not really wrong per se.

But finding excuses is one thing. If you fail publicly as analysts typically do with their forecasts and fund managers with their portfolios, how do you change your forecast (or your investment position)? My colleague at Liberum and Professor at Loughborough University Ken Lee and his collaborators have interviewed 18 equity analysts on how they dealt with forecasts gone wrong and what they did when they ‘threw in the towel’ and U-turned on their recommendation.

First, they noticed that shame was a major driver of the reluctance to recant a failed recommendation. After all, nobody likes to be humiliated in public and I can attest to this. Having to revise a call is not only humiliating, but it saps your confidence. You start to question not just the failed forecast but every forecast you ever made. This feeling of despondency and humiliation is exacerbated by several key factors:

1. How important is the forecast to the analyst’s franchise? Is the analyst a widely followed expert on the stock or is this a stock the analyst covers but is not central to his or her reputation?

2. Are external factors at play? Analysts have a much easier time revising their forecasts when external events like changing regulations or system-wide changes have led to a failed forecast. It provides them with a rationalisation along the ‘ceteris paribus’ excuse above.

3. How bold was the recommendation? If you stick your head out and it gets chopped off, it is much more humiliating than revising a cautiously phrased and nuanced forecast.

4. How fast did it go wrong? Imagine having to backtrack on a forecast that went wrong almost from the start vs. one that went wrong slowly over a year or so.

5. How impactful was the forecast to begin with? If a forecast gets a lot of traction with investors, analysts are far more reluctant to retract it since they can expect a more pronounced backlash.

What to do then?

If you ask me, being honest and transparent about your mistake, going out in public with your hat in hand and telling everyone you were wrong and why you were wrong (no excuses, please) is the best policy. In my eyes, and in the eyes of many others, this will enhance your reputation, not reduce it. In fact, using excuses is a sure-fire way to damage your reputation and erode your customers’ trust. Always remember the trust equation:

Trust = (Credibility + Reliability + Intimacy) / Self-orientation

If an analyst is looking for excuses, it increases the perception of self-orientation and self-interest. Customers feel the analyst is trying to protect himself by throwing other people under the proverbial bus. An analyst (or fund manager or corporate executive, etc.) who stands up and admits being wrong reduces the perception of self-orientation and thus increases trust.

Unfortunately, that is not what the typical analyst (or fund manager or corporate executive, etc.) does. Instead, the research found three common ways to deal with failed forecasts:

1. Head in the sand: A reluctance to deal with a failed forecast and failure to revise it for as long as possible.

2. Paralysis: When finally capitulating on a failed forecast, many take the easy way out, put a Hold recommendation on the stock under coverage and remain on the sidelines for a long time.

3. Babies and bathtubs: Instead of revising one failed forecast, analysts revise their entire coverage and change everything wholesale as they perceive they may have overlooked something systemic. This can sometimes be the right thing to do, but often is simply a reflection of drained self-confidence.

In my career I have experienced several situations where I was widely off the mark with my forecasts and my natural instinct was to protect my fragile ego by looking for excuses. And I admit I have used all three coping techniques myself when faced with failed forecasts. But none of them worked in the long run. Instead, I found that by admitting to mistakes and honestly assessing them in a post-mortem – even if that means public humiliation – my forecasts got better over time because I learned from past mistakes. And I think this is by far the most constructive way to deal with mistakes. Be a man about them, not a coward.