Why are market forecasts so unreliable?

10 Apr 2014

By Patrick Fagan

It is often suggested that some of the smartest people in the world work in financial markets. Unfortunately, intelligence doesn't necessarily equate to the ability to correctly and consistently predict the movements of markets and individual securities. A number of factors explain why such predictions are so much more difficult than many people assume.

Forecasting – not a precise science

A forecast for an individual stock depends on a variety of assumptions. If just one of those assumptions proves incorrect, the forecast can be completely wrong. Interesting examples include Research in Motion (maker of the Blackberry mobile), Apple Inc. and the Tokyo Electric Power, who operated the Fukushima nuclear power plant in Japan.

In 2009, Research in Motion was receiving positive reports from numerous research analysts and brokers as popularity of the Blackberry device increased. However, things went quickly downhill for Research in Motion and by May 2012 its shares were trading at a fraction of the prices seen in 2009.

What the market and analysts didn't foresee was the phenomenal take–up of the Apple iPhone and devices running Google's Android operating system.

In early 2011, the nuclear power station operator Tokyo Electric Power (Tepco) was considered by many analysts as a stock with strong earning potential. On 11 March 2011, a devastating earthquake and tidal wave crippled the company's Fukushima nuclear power station, leaving thousands dead and forcing 160,000 people from their homes.

Of course, nothing can compare to the human losses of that disaster. But over the 16–month period from the disaster to the end of April this year, Tepco was the worst performing stock on the Japanese equity market, falling nearly 90 percent in value. Tepco is now facing billions in compensation claims and has been seeking tens of billions in public funds to avert an outright collapse.

Safeguarding your future

Forecasting in financial markets is difficult because the assumptions underpinning a forecast can come undone, sometimes in spectacular fashion. Moreover, it is hard because accurate forecasting involves both a consideration of all the factors and a reliable prediction of events before they occur.

The possibility of industry–specific or stock–specific factors damaging an investment's value is the reason we should diversify – across stocks, across asset classes, across industries and across countries. The purpose of diversification is to reduce the severity of unexpected events. So my advice - expect the unexpected and diversify.

To learn more about Patrick, view his online profile.

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