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Financial Forecasting [Finance
Posted on March 2, 2016 @ 10:55:00 AM by Paul Meagher

I am halfway through Philip Tetlock and Dan Gardner's book Superforecasting: The Art & Science of Prediction (2015). Bloomberg suggest that this is the third most important book for investors to read over the spring break. With all due respect to Elon Musk and the Originals, I would probably rank this book #1 because of its' timeliness.

One current event that makes the book timely is the US Presidential elections and the race to predict who will be the next US President as well as the outcome of all the skirmishes along the way. A new group of people who will be given credibility in predicting these results will be the people that Philip Tetlock's research program has identified, through testing, as superforecasters. These are people who come from different backgrounds but who share the feature that they are significantly above average in predicting the outcome of world events.

The superforecaster club appears to be an elite group of prediction experts. Philip and Dan analyze what makes them tick in the hopes of helping us all become better at predicting the future. Many of the questions that Philip and Dan ask them are the types of geopolitical questions security intelligence agencies want to have answers to so that they can properly prepare for the future. Much of the research that is reported comes from research sponsored by intelligence agencies. Intelligence involves alot of prediction work so this makes sense.

The second reason why this book is timely is because this is tax time for many people and there is probably no better time of year to figure out a financial forecast for next year. You have your financial performance from last year clear in your mind and your are now 2 months into 2016 and have some current data to integrate into your forecast for 2016. So around now is a good time to exercise your prediction muscle and come up with a 2016 financial forecast. If you don't seriously exercise your prediction muscle don't expect your prediction abilities to get any better.

One prediction that small businesses are required to make each year is their expected income in order to make appropriate quarterly income tax payments. One reason superforecasters are good at predicting the future is because they are good at breaking down complex prediction problems, like yearly financial forecasts, into smaller and easier prediction problems. If asked to evaluate whether Hillary or Trump will win, they don't try to predict the question as it stands. They break it down into all the things that would have to be true in order for the Hillary or Trump presidential outcome to happen and evaluate the likelihood of those component outcomes. Similarly, to come up with a good financial forecast for next year you need to break your prediction down into expense and income buckets and try to estimate how full those different buckets will be.

One business expense that I claim are the books I purchase for educational or blogging purposes. How much will I spend on books in 2016? If I can nail this down fairly well and then nail down how much I'll spend on keeping my vehicle on the road and so on, then I should come up with a better forecast of my expenses for 2016 than if I just used my overall expenses from 2015 as my guide to forecasting my 2016 expenses. One way to improve your tax season experience is to look at it as an opportunity to improve your forecasting skills in a domain where you can get good feedback on your forecasting accuracy. To be become better at forecasting it is not enough to simply make forecasts, you also have to evaluate how well your forecasts did and this is relatively easy in the case of financial forecasting (next year's income taxes will tell you how accurate you were).

So back to forecasting my book expenses for 2016. Superforecasters are good at taking an outside view of the prediction problem before taking an inside view. The outside view is the objective view of the situation. They ask what might be the relevant numbers, statistics, and base rates upon which I can base my forecast. In my case, I can log into Amazon and see how many books I have purchased so far from them in 2016 and use the amount spent so far to project what I'm likely to spend this year. Once I have these numbers than I can take the inside view and ask whether my rate of reading is likely to persist for the rest of the year. As spring and summer approaches, and I spend more time at the farm, I expect my reading to go down. Even though my reading rate may go down, I nevertheless expect to keep investing at that rate of 1 book a week because my new years resolution was to read a book a week.

So one book a week at an average price of around $30 per book leads me to make an exact prediction of $1,560 (52 weeks x $30 per book) as the expected total for my 2016 book expenses category.

Another feature of superforecasters is that they are not afraid to do a little math. It is hard to assimilate forecast feedback if you don't compare forecasted and actual numbers. Comparing forecasted and actual numbers is trickier than just comparing two single numbers. It is at this point, however, that I want to conclude this blog because I think it will take another blog to address the issue of specifying and evaluating forecasts. I also have the second half of the book to read :-)

To conclude, the Superforecaster book is a timely book to read. Financial forecasting is arguably one of the best arenas in which to develop forecasting skill as it involves breaking down a complex prediction problem into simpler prediction problems and the opportunity to gather feedback regarding your forecasting accuracy. Financial forecasting is also a very useful skill so it is a good arena in which to hone forecasting superpowers.

In my next blog on this book/topic I'll address some of the math associated with specifying and evaluating forecasts.

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