Whither Forecasting? The Butterfly Stirs …

Weathered

Earnings forecasting is a triumph of accountancy over reality: given the complexity of most corporations an accurate forecast of earnings is logically, and numerically impossible.  Yet corporations guide and analysts analyse and, mostly, they all end up looking wise.

It’s all nonsense, of course.  The economy is a complex adaptive system comprised of billions of working parts.  The realistic chance of anybody predicting anything minutely accurate about anything of any interest is approximately zero, to several decimal points.  As any weather forecaster could tell you.

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On Incentives, Agency and Aqueducts

Risk Management, Roman Style

There’s an aqueduct in Segovia, in Spain, that’s stood the test of time. A lot of water has flowed over that bridge … two thousand years worth, more or less, since it was built by the Roman Empire. Back then risk management consisted of getting the chief engineer to stand underneath the structure when they removed the supports: now that’s a proper incentive.

Incentives stand at the heart of a lot of human behaviour in corporations but financial theorists have had a great deal of difficulty in understanding that an incentive is not necessarily the same as a financial reward. Although the ideas of psychologists and sociologists are slowly seeping through there’s still a long way to go before there’s a proper appreciation of what motivates people. In the meantime we’re stuck with Agency Theory, the sheer power of grim self-interest: it’s like real life but not as we know it.

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Are IPO’s Bitter Lemons?

In Used Car Dealers We Trust

The Initial Public Offering (IPO) market exposes investors to a classic problem of asymmetric information: there’s not much doubt that the insiders know far more about the true worth of their company than do potential purchasers. So, as outlined by George Akerlof in his classic treatise on the used car market, we would expect that the only companies on offer in this market should be the ones you really don’t want to buy; companies with sticky accelerators and malfunctioning brakes.

Traditionally there’s a way around this impasse, the use of trusted intermediaries whose skill and judgement can be relied on by potential investors to overcome the urge of company owners to maximise their gains and who can distinguish the dross from the jewels. Bizarrely the result of this intervention supposedly sees companies floating at valuations below their real value but, unfortunately, this comes with the ever-present risk of abuse by trustees. Situation abnormal, as usual.

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Akerlof’s Lemons: Risk Asymmetry Dangers for Investors

The Failure of Markets

Ever since Adam Smith identified the raw stuff of market economics and David Ricardo explained the concept of comparative advantage genuine new ideas in economics have been as rare as a vegetable in a child’s dinner. However, market economics doesn't always work – as Hardin showed, in The Tragedy of the Commons, where resources are shared then market economics breaks down – which may be a disaster when the common resource is the air we breathe.

In 1970 George Akerlof came up with another mechanism to disturb the most rampant of free-marketeers, demonstrating that there are times when markets fail even when there are both willing buyers and sellers. His work suggests that similar problems may dog investors as they try to make an honest turn on the markets through small cap stocks or mutual funds.

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