By Alexander Ineichen, CAIA, CFA, FRM
At the beginning of 2019, 50 out of 50 economists surveyed by the Wall Street Journal thought that 10-year Treasury yields wouldn't fall below 2% during the year. They did. Remember:
The herd instinct among forecasters makes sheep look like independent thinkers.[1]
—Edgar Fiedler (1929-2003), American economist
At the beginning of 2020, almost all the forecasts for the year were a laughing matter by the end of February. Something microscopically small changed everything and made any forecast for the year worthless. It is not only financial strategists and economists who should refrain from forecasting, historians should avoid it too:
It is always a mistake for the historian to try to predict the future. Life, unlike science, is simply too full of surprises.[2]
—Richard J. Evans (b. 1947), British historian
Forrest Gump’s mother said pretty much the same thing:
My momma always said, "Life is like a box of chocolates. You never know what you're gonna get." [3]
—Forrest Gump, fictional soldier, runner, entrepreneur, and early Apple investor
One ought to know what one doesn’t know. Wizards err. In Applied Wisdom I call this Gump’s law in honor of Forrest’s mum.[4]
In 1993, the Organization for Economic Cooperation and Development (OECD) analyzed forecasts made between 1987 and 1992 by various governments, as well as by the International Monetary Fund (IMF) and the OECD itself. The governments and the IMF should have guessed or flipped a coin, rather than forecast: Not only were the forecasts abysmally wrong, but they would have been better forecasts had they binned their models and simply assumed that the numbers would be the same as the year before.[5]
Expert failure is consistent with dysrationalia, i.e., the concept of really smart people making really stupid mistakes. It is also consistent with the Nobel disease, i.e., the concept of highly educated people like Nobel prize-winners endorsing or performing “research” in pseudoscientific areas in their later years. Award-winning science journalist David Robson even goes as far as suggesting that really smart people can be more perceptible to nonsense or pranks:
Not only do general intelligence and academic education fail to protect us from various cognitive errors; smart people may be even more vulnerable to certain kinds of foolish thinking.[6]
—David Robson (b. 1985), British science writer
In 1998, Paul Krugman, a Nobel laureate, predicted that the economic impact of the internet would be about as large as the invention of the fax machine.[7] Around the same time, David Bowie, a singer, said in an interview that the internet will be “huge” and would change everything.[8] This is only one of many examples in which street-smartness trumps book-smartness.
Knowledge and Ignorance of Ignorance
Economist John Kenneth Galbraith put it most eloquently.
One of the greatest pieces of economic wisdom is to know what you do not know.[9]
—John Kenneth Galbraith (1908-2006), Canadian-American economist
Leave out the word “economic” and the quote works just as well. Knowing what you do not know is easier said than done though:
It takes considerable knowledge just to realize the extent of your own ignorance.[10]
—Thomas Sowell (b. 1930), American economist
The idea of knowing one’s limitations, including one’s own ignorance, is incredibly old. Old is good. Old means battle-tested. Concepts and ideas that are not applicable disappear over time. Concepts and ideas that are applicable survive over time. This one has survived:
Real knowledge is to know the extent of one’s ignorance.[11]
—Confucius (551–479 bc), Chinese philosopher
The idea that one ought to know what one does not could well be more than three thousand years old:
True wisdom is less presuming than folly. The wise man doubts often, and changes his mind; the fool is obstinate, and doubts not; he knows all things but his own ignorance.[12]
—Akhenaton (c1385–c1350 bc), Egyptian pharaoh, or Kemetic saying, or ancient Egyptian proverb
Yoda and the Invisible Gorilla
The practical investment relevance is that ignorance of one’s ignorance is risky:
Ignorance per se is not nearly as dangerous as ignorance of ignorance.[13]
—Sydney J. Harris (1917–86), American journalist
To Sydney Harris’s point:
Bear Stearns is fine! Keep your money where it is.[14]
—Jim Cramer (b. 1955), American television personality
To Jim Cramer’s point:
Difficult to see. Always in motion is the future.[15]
—Yoda
This means, with regards to the future, we are blind, and it is especially important that we know about the degree of our blindness. Daniel Kahneman, cocreator of prospect theory, points out two important facts about our minds in relation to the fascinating invisible gorilla:
We can be blind to the obvious, and we are also blind to our blindness.[16]
—Daniel Kahneman (b. 1934), Israeli-born American psychologist
The invisible gorilla is a selective attention test in video format. The video shows two groups of people passing basketballs. One team is wearing white shirts, the other black. The viewer is instructed to count how many times the players wearing white shirts pass the basketball. Twenty-four seconds into the video an actor in a gorilla suit walks into the frame center, pounds his chest, and moves on. The fascinating bit is that only around 50 percent of viewers see the gorilla when watching for the first time. They are too busy counting passes. They are blind to reality and quite surprised about their blindness once it has been revealed to them.
Accidents and Cleopatra’s Nose
In a book called Normal Accidents, sociologist Charles Perrow examines failures of man-made systems (power plants, airplanes, etc.). He makes the point that it is human nature to find someone to blame for an accident. We want to know the “cause.” However, Perrow argues that the cause of an accident of a man-made system is to be found in the complexity of the system.
The odd term normal accident is meant to signal that, given the system characteristics, multiple and unexpected interactions of failures are inevitable.[17]
—Charles Perrow (1925–2019), American sociologist
An accident that results in a catastrophe is often a series of small events that, viewed by themselves, seem trivial. It is the interaction of multiple failures that can explain the accident.[18] Patient accident reconstruction often reveals the banality and triviality behind most catastrophes. In other words, great events can have small beginnings.
Chaos theory suggests, among other things, that meaningful events, accidents, disturbances, etc., can have a trivial beginning. This has been known for a while:
The beginnings of all things are small.[19]
—Cicero (106–43 bc), Roman politician, orator, and philosopher
Cleopatra’s nose was trivial; the actions taken by Julius Caesar and Mark Antony to win her over were not.
Cleopatra’s nose, had it been shorter, the whole face of the world would have changed.[20]
—Blaise Pascal (1623–62), French mathematician
The idea of chaos theory suggests that what appears to be an overly complex, turbulent system (origins of life on Earth, weather, financial markets, etc.) can begin with simple components (amino acids, water, day traders, etc.), operating under a few simple rules (photosynthesis, evaporation, buy low/sell high, etc.). One of the characteristics of such a system is that a small change in the initial conditions, often too small to measure, can ultimately lead to radically different outcomes or behaviors.
Sensitivity to initial conditions is popularly known as the butterfly effect, so-called because of the title of a paper given by Edward Lorenz, the American mathematician, meteorologist, and pioneer of chaos theory, in 1972 to the American Association for the Advancement of Science, in Washington, DC, entitled “Predictability: Does the Flap of a Butterfly’s Wings in Brazil Set Off a Tornado in Texas?” The flapping wing represents a small change in the initial condition of the system, which can cause a chain of events leading to large-scale phenomena. Had the butterfly not flapped its wings, the trajectory of the system might have been vastly different.
The butterfly effect is very much applicable to financial systems. Richard Bookstaber, who had chief risk officer roles on both the buy-side at Moore Capital and Bridgewater, and on the sell-side at Morgan Stanley and Salomon, and from 2009 to 2015 also served in the public sector at the SEC and the US Treasury, writing on systemic risk in a book published prior to the 2008 financial crisis, put it simply:
Systems with high levels of interactive complexity are subject to failures that seem to come out of nowhere or that appear unfathomably improbable.[21]
—Richard Bookstaber (b. 1950), American risk manager and risk researcher
Markets and economies are systems with high levels of interactive complexity. Furthermore, like the weather, they are chaotic. Next time you hear someone predict the stock market, interest rates, or inflation one year hence, you now know how seriously to take the forecast(er):
Personally, I think everybody who predicts the future with a straight face should be required (by federal law) to change out of the business suit, wrap him/herself in a gypsy shawl, wear one of those pointed wizard’s hats with a picture of a crescent moon on it, and make conjuring sounds over a crystal ball. That way, everybody would know exactly what’s going on.[22]
—Robert N. Veres (b. 1951), Author
Putin and the Klingons
Government intervention is like an option: it can be erratic and surprise markets and can be the trivial trigger for big events to unfold. The investor is short that option. Expropriation is one example. As China-born, London-based, Australia-raised Sir Michael Hintze, founder of CQS, a hedge fund, put it in 2013 in relation to Europe becoming a bit more aggressive in going after its citizens’ money:
One of the things that concerns me in the context of the Eurozone is expropriation. Cyprus was a bail-in, with depositors’ savings taken away to make up for the shortfall and it was done at the direction of government. This now seems to be the new template.[23]
—Sir Michael Hintze (b. 1953), British-Australian hedge fund manager
Michael Hintze’s grandparents fled Russia after the 1917 Bolshevik revolution; hence, speculating a bit, Mr. Hintze is sensitive to expropriation. Vladimir Putin, formerly with the KGB, did not appreciate the Cyprus bail-in of 2013 and expropriation of Russian “investors” either. Before the bail-in, he said:
Such a decision, if it’s adopted, will be unfair, unprofessional and dangerous.[24]
—Vladimir Putin (b. 1952), Russian politician
Many Russian oligarchs have “invested” in Cyprus; hence Putin’s unease of the Eurozone’s sticky fingers. Tensions with Russia, Russia being classified by George Soros in Davos in January 2018 as a “dictatorship and Mafia state,” can escalate. The First World War was not started because Bosnia’s Che Guevara, Gavrilo Princip, shot Franz Ferdinand and his wife. This might have been the trivial trigger, the butterfly’s wing flap that caused the first domino to fall. Big events can have trivial beginnings, as Cicero mused earlier. Whether Mr. Putin had a Klingon proverb in mind when he said the above, I do not know. He might have.
Fool me once, shame on you.
Fool me twice, prepare to die.
—Klingon proverb
Nowcasting and a night at Nobu
Nowcasting is an alternative to taking forecasts seriously. A point could be made that decision-making in finance will become more systematic, disciplined, and oriented toward risk rather than returns. Nowcasting might be an important stepping stone on that path.
The term nowcasting is a contraction of “now” and “forecasting.” Nowcasting is a reasonably new word, at least in economic finance. It is either the opposite of forecasting or simply a pun on the word “forecasting.” The term is used in both economics and meteorology. A forecaster tries to predict the future. Empirically, this has proven quite a challenge in many endeavors related to human action as alluded to earlier and as Mark Twain or Yogi Berra or Niels Bohr might have put it:
It is difficult to make predictions,
especially about the future.[25]
—Adage
In 2015, I claimed that nowcasting is to forecasting what astronomy is to astrology. The term “nowcasting” in an economic context can be defined as follows:
Nowcasting, def.: Nowcasting is the economic discipline of determining a trend or a trend reversal objectively in real time. Nowcasting is fact-based, focuses on the known and knowable, and therefore avoids forecasting. Nowcasting is the basis of a robust decision-making process.[26]
—IR&M’s definition of nowcasting
SARS-CoV-2 is microscopically small but is having a large impact on almost everything. The uncertainty due to current policy measures, bureaucracy inflation, and, in the United States, campus liberalism, all contribute to the uncertainty, making forecasting an almost silly endeavor.
We really can’t forecast that well. We pretend we can, but we can’t. Markets do very weird things because it reacts to how people behave and sometimes people are a little screwy.[27]
—Alan Greenspan (b. 1926), American economist and former chairman of the Federal Reserve
Science writer Mark Buchanan, writing not on January 7, 2021, after hooligans stormed Capital Hill (the typo was left as a pun) but in the year 2000, recommends expecting the unexpected:
[W]e should learn to expect the unexpected. We live now in a time that is relatively peaceful. This relative calm may endure for another century, or we may see another world war in five years—no one can really say. The United States as a nation may survive for another five hundred years, or crumble in thirty.[28]
—Mark Buchanan (b. 1961), American physicist and author
This last quotation, self-serving as it might be in my case, suggests both nowcasting, i.e., non-guessing the future, as well as active risk management. On Mark Buchanan’s point: learning to expect the unexpected is a good attitude and has broader applicability, such as in family planning, for example:
Expect the unexpected.[29]
—Boris Becker (b. 1967), German tennis player
Sometimes something as trivial as a night out at a Japanese celebrity chef’s restaurant in London can have a life-changing afterplay.
About the Author
ALEXANDER M. INEICHEN, CFA, CAIA, FRM, is founder of Ineichen Research and Management (IR&M), an independent research firm established in 2009 focusing on investment themes related to nowcasting and risk management. He also is a board member of the CAIA Association.
Alexander started his financial career in derivatives brokerage and origination of risk management products at Swiss Bank Corporation in 1988. From 1991 to 2009 he had various research functions within UBS in Zurich and London relating to derivatives, indices, capital flows and alternative investments.
He is the author of two white papers, In Search of Alpha and The Search for Alpha Continues, that were the most often printed research publications in the documented history of UBS. He is author of two books that provide his manifesto for active risk management, Absolute Returns and Asymmetric Returns. His third book, Applied Wisdom, is scheduled for November 2021.
REFERENCES
[1] Edgar Fiedler, Across the Board 14 (June 1977): 62–63.
[2] Richard J. Evans, In Defence of History (London: Granta Books, 1997), 62.
[3] Robert Zemeckis, director, Forrest Gump (Hollywood, CA: Paramount Pictures, 1994). Fun fact: The quotation is ranked fortieth in the American Film Institute’s list of the top hundred movie quotations in American cinema. “I’ll be back” is thirty-seventh. “We’ll always have Paris” is forty-third. “Frankly, my dear, I don’t give a damn,” from Gone with the Wind, was first.
[4] Alexander Ineichen, Applied Wisdom (New York: Radius Book Group, 2021), forthcoming.
[5] From Mark Buchanan, Ubiquity: Why Catastrophes Happen (New York: Three Rivers Press, 2000), 140, with reference to OECD Economic Outlook, June 1993.
[6] David Robson, The Intelligence Trap: Revolutionise Your Thinking and Make Wiser Decisions (London: Hodder & Stoughton, 2019), 3.
[7] Paul Krugman, “Why Most Economists’ Predictions Are Wrong,” The Red Herring, June 10, 1998.
[8] David Bowie, Newsnight, interview by Jeremy Paxman, BBC, 1999.
[9] John Kenneth Galbraith, Time magazine, March 3, 1961, 20.
[10] Thomas Sowell, “A Childish Letter,” Jewish World Review, August 17, 1998.
[11] There are many variants of this quotation in relation to one’s ignorance of ignorance. The origin of the idea, I believe, is from The Analects, Chapter II. The Analects are a collection of sayings and ideas attributed to the Chinese philosopher Confucius and his contemporaries, traditionally believed to have been compiled and written by Confucius’s followers.
[12] As quoted in Larry Chang, Wisdom for the Soul of Black Folk (Washington, DC: Gnosophia, 2007), 359.
[13] Sydney J. Harris, Pieces of Eight (Boston: Houghton Mifflin Harcourt, 1982).
[14] As quoted in Jack Schwager, Market Sense and Nonsense: How the Markets Really Work (and How They Don’t) (Hoboken: John Wiley & Sons, 2013), 3–4.
[15] George Lucas, Star Wars: Episode V—The Empire Strikes Back (Burbank, CA: Twentieth Century Fox, 1980).
[16] Daniel Kahneman, Thinking, Fast and Slow (New York: Farrar, Straus and Giroux, 2011), 24.
[17] Charles Perrow, Normal Accidents: Living with High-Risk Technologies (Princeton: Princeton University Press, 1999), 5. Emphasis in the original. First published in 1984 by Basic Books (New York).
[18] Charles Perrow, Normal Accidents, 7.
[19] From Cicero, De Finibus Bonorum et Malorum (45 bc), book V, chapter 58. Variant translation: “Everything has a small beginning.” Another variant, sourced from Orationes Philippicae V, reads: “The most important events are often determined by very trivial causes.”
[20] Blaise Pascal, Pensées (1658), no. 32.
[21] Richard Bookstaber, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation (Hoboken: John Wiley & Sons, 2007), 155.
[22] Robert N. Veres, “The Vision Thing,” Investment Advisor, June 1997.
[23] Michael Hintze, “Global Review,” HedgeFund Intelligence, Autumn 2013.
[24] Vladimir Putin on the at that time proposed a penalty on Cypriot bank deposits, quoted from Ilya Arkhipov and Henry Meyer, “Putin Says Cyprus Bank-Deposit Levy Is Dangerous, Unfair,” Bloomberg, March 18, 2013.
[25] There are many variants of this quote, attributed to all sorts of people, including Mark Twain, Niels Bohr, Samuel Goldwyn, Yogi Berra, Nostradamus, among others. Quote Investigator (March 21, 2017) finds the earliest recording of this quotation in Denmark. The Danish politician Karl Kristian Steincke (1880–1963) referred to it in his autobiography, overheard in the parliamentary year of 1937–38, although no attribution was given.
[26] First published in Alexander Ineichen, “Nowcasting and Financial Wizardry,” IR&M, January 2015. An alternative definition of nowcasting is the following: “Now-casting is defined as the prediction of the present, the very near future, and the very recent past.” From Marta Ba?bura, Domenico Giannone, Michele Modugno, and Lucrezia Reichlin, “Now-Casting and Real-time Data Flow,” European Central Bank, Working Paper Series, No 1564 (July 2013). (The reason why it makes sense to forecast the most recent past is that official economic data is released with a long delay. Nowcasting, therefore, predicts the past before the past is known, sort of. There is empirical evidence that markets and the economic cycle are coincident, making the case for using nowcasting as an investment tool for asset allocation and/or risk management.)
[27] Alan Greenspan, “Interview,” The Daily Show, Jon Stewart, October 21, 2013.
[28] Mark Buchanan, Ubiquity: Why Catastrophes Happen (New York: Three Rivers Press, 2000), 239.
[29] Adam Johnson, Bloomberg TV, October 9, 2013.