The Perils of Forecasting

In today’s WSJ Econoblog, there is a terrific discussion on a favorite subject of mine: The Perils of Forecasting.

I’m not saying that just because I am linked in it; this is a subject near and dear to me. Recall last year, I wrote a column for the Apprenticed Investor series titled, The Folly of Forecasting. It discussed the perils of predictions — I find the alliterative titles irresistible — and noted that investors all too often give "predictions" far more weight than they should.

The debate is ably handled between two econ profs: James D. Hamilton, of UC San Diego, who’s blog is Econbrowser, and Kash Mansori, of Colby College, who runs the Angry Bear.

Here’s an excerpt:

JH:  "There is both theoretical and empirical evidence against this martingale hypothesis. When investors care about avoiding risk, for example, there could be higher expected returns in times when the stock is more risky to hold. But there is no question that the martingale description is a pretty good first approximation to the behavior of most stock prices.

Actually, economic theory suggests that not just stock prices but a great number of other economic magnitudes of interest should exhibit near-martingale behavior. Predictable price changes in any commodity that can be stored, for example, can be arbitraged away by increasing or decreasing current inventories. Such inventory adjustment again would result in the current price jumping to the value that best reflects the expected future price. Although costs of storage, changing inventories, and other benefits from holding inventories can introduce the possibility of more complicated dynamics, a martingale proves to be a good approximation to exchange rates and many commodity prices."

Next up: Kash:

KM:  Why do economists sometimes get their forecasts wrong in such systematic and persistent ways? Why aren’t they better at adjusting their forecasts?

I think that such episodes point out that the economy is constantly evolving in subtle but substantial ways that can take a long, long time for economists to understand. The economy of the 1990s was truly different from the economy of the 1980s, in ways that we’re still trying to figure out. The labor market of the past few years is truly different from previous economic recoveries, and we’re not quite sure why.

These continual changes in how the economy works put economists at a huge disadvantage in making forecasts, particularly compared to, for example, meteorologists. The nature of physical and chemical interactions in the atmosphere never change, but the nature of economic interactions change constantly!

Its good stuff — worth the read!

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Source:
The Perils of Forecasting
ECONOBLOG,January 26, 2006
http://online.wsj.com/article/SB113810608408354680.html

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http://tinyurl.com/c9x8u

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