We Are All Forecasters, Get Over It

October 3, 2014

3 minute read

I love Larry Swedroe’s work. If you haven’t read some of his books on investing then you’re probably less informed than you otherwise could be. But Larry also believes in the “forecast free” view on indexing. And while it’s a nice message and one that we can all relate to (forecasting is hard), I think it misrepresents what we all do when we allocate assets.

In a recent blog post Larry says that prognosticating the future is “the occupation of charlatans”. That’s pretty harsh if you ask me. But we see this all the time with indexers. They say that they don’t predict the future, don’t engage in trying to outguess the market and that they leave that up to the “active” gamblers. And then they whip out their handy dandy set of backtested results and datamined “evidence” and say “buy low fee index funds and don’t listen to anyone who makes a forecast”. Or they look at past results and conclude that certain “factors” should be weighted in a certain way because they have shown evidence of good performance. Or they choose to actively deviate from global cap weighting (as all indexers do) and then claim they’re still not predicting the future.

This is all fine except for one small problem – by using a rear view mirror approach the indexers are all making forecasts. They’re just extrapolating the past into the future in what amounts to little more than “well, asset classes have averaged X% per year for XXX years so that’s a reliable assumption going forward”. This could be true. And it could also be completely wrong. They’re making a fairly smart forecast based on a fairly long dataset, but it’s not like they’re not making a forecast about the future.

Worse, as I’ve noted recently, indexers all deviate from the global market cap weighting because no indexer can buy the total world’s financial assets nor would they want to. And when you deviate from global cap weighting you are, by definition, an active investor. And you are, by definition, making a forecast about how your allocation will perform in the future. I don’t care if you look at some historical dataset and extrapolate it forward or if you focus on trying to understand the world for what it is and make probabilistic forecasts (as I do). We all make forecasts about the future. Some do it in rather silly ways while I’d argue that some are more realistic and calculated. But all of our portfolios are constructed by making forecasts and implicit assumptions about how certain asset class weightings will help us achieve our financial goals.

Of course, the future is extremely difficult to forecast. We don’t deal in certainties in life. We deal in probabilities. Which is fine. I don’t know what the weather will be like in one month (except, actually I do know what it will be like here in San Diego), but that doesn’t mean I start throwing my beer at the TV every time a weather man comes on. Constructing a portfolio is a lot like forecasting the weather where you want to get married. You pick a place where it likely won’t rain, a time of year where it doesn’t rain much and then you cross your fingers and hope that your probabilistic forecast was smart. But you don’t just go and get married anywhere in the world just because the weather is difficult to predict.

We deal in a very complex system in the financial markets. But don’t be the person who goes into all of this using some backtested set of results that you extrapolated into the future thereby leading to the silly conclusion that you aren’t making forecasts. Doing that would just make you a charlatan and someone who, if I ever met you, I might just have to waste a perfectly good beer on (literally, on you). Just kidding, I would never waste a perfectly good beer on someone who believes in “forecast free passive indexing”. Unless it was in the process of erasing such a terrible misconception from your mind. Which might require more than one beer….