How much would you pay for a glass of water? Alternatively, what is a glass of water really worth? The answer of course is that it all depends.
Water from the tap is virtually free, at only 0.002 cents per litre, and in Australia and the US our water is very clean and safe. However, we are prepared to pay around $2.50 per litre for bottled water, partly for the convenience, and partly because it is considered to be of a higher quality (although this is questionable). That’s a big increase for something that is a little more convenient and pure – 125,000 times more expensive!
One of the most significant determinants of price is the cost of production. Because bottled water undergoes additional filtering and requires packaging and transport it tends to cost a lot more. But the point is if we put on our analyst hats we can objectively determine the current cost of production, apply a suitable margin and calculate a reasonable price. Estimations may vary, but they typically won’t vary by too much.
A much harder question is: what will a bottle of water be worth in one year’s time? All of a sudden we need to make a whole host of assumptions (ie guesses) and depending on what values we estimate for all the variables involved, we can arrive at a very wide range of possible answers.
Will the supply of water remain mostly unchanged over the next year, or will there be droughts or flooding rains? Will the cost of fuel change and in turn impact the cost of transport? Will community attitudes change (as they are currently) and will this impact the demand for bottled water? Will there be a health scare, such as another Giardia or Cryptosporidium outbreak, and if so how serious will this be and how will it impact demand? There are a host of other important variables, and all we are talking about is a simple bottle of water!
Because business earnings, particularly those for large listed entities, are dependent on a much wider array of variables the process of forecasting is many orders of magnitude more difficult. Even if we could determine future earnings with reasonable accuracy, what is the best way of relating this to a company’s share price?
Once you understand this it becomes quite obvious why analysts’ forecasts can vary by so much, and more importantly, why these forecasts are notoriously inaccurate. We live in a complex, chaotic and ever changing world and the fact is that predicting the future with precision is very, very difficult to do.
One of the greatest problems is with so called ‘Black Swan’ events. Events that are not only unpredictable but entirely unprecedented. Moreover they tend to have significant ramifications. 9/11, the internet and World War 1 are all examples of Black Swans. To return to our water analogy, what would happen to the price of a bottle of water if terrorists poisoned the water supply for all of the major US cities? An analyst would be very unlikely to include this possibility in their forecast, but that doesn’t mean it can’t happen and won’t have serious consequences to the price of bottled water.
I’m not trying to argue that forecasting is a waste of time; indeed it allows us to bring a measure of objectivity to our expectations. The problem arises when we start treating forecasts as immutable facts and unfortunately this is a very common mistake made by investors. If a given prediction fails to come to pass, investors will often blame everyone but themselves and can become very bitter towards the process of stock market investing.
But just because we can never know the future with precision doesn’t mean that all is lost, we simply need to account for it in our investment plan. After all, we tend to account for it in other areas of our lives. For example most people insure their houses and cars, and many also insure their income because when it comes to these types of things we recognise the fact that almost anything can happen. Beyond insurance, people will tend to limit their risks in other ways, such as by installing smoke alarms or by simply taking sensible precautions, such as taking care when crossing the road.
So if you invest a significant part of your capital in just one investment, even one that is supported by most experts, understand that you are exposing yourself to significant risks. It might be a large, 100 year old blue chip company, but that doesn’t mean it is necessarily safe (look at GM or Fannie Mae). Spread your risk around by diversifying your investment capital, consider hedging your positions, focus on the longer term and ensure you have a clear exit strategy.
Investors should certainly consider forecasts and position their portfolios to take advantage of expected moves – after all, investment is essentially a bet on the future. Nevertheless we need to remain cognisant of the fact that forecasts are fallible and ensure we are prepared for unexpected eventualities. As any general will tell you: Plan to win, but prepare for defeat.
Make the markets work for you