Monday, July 13, 2009

Predicting the Future – Ari Paul

Trying to predict the future is usually a humbling if not embarrassing endeavor. Industry titans are often famously wrong in their areas of expertise (e.g. “640K [memory] ought to be enough for anybody” – Bill Gates 1981). Many top investors and traders simply give up trying. The father of value investing, Ben Graham, said he thought predicting future interest rates or which companies will grow faster than others, was so difficult as to be unworthy of the attempt. Most top traders seek to take advantage of brief inefficiencies or trends but avoid longer term “macroeconomic” bets. So, should we avoid speculating on the future altogether?

By “speculating on the future”, I mean trying to predict cultural, economic, or political conditions more than 3 years ahead of time. Will interest rates be higher or lower in 3 years? Which party will be in power? Will the world be in crisis or well into a new bull market? Many smart investors simply ignore these questions and focus on buying good companies at cheap prices, confident that this strategy will produce superior returns in the long run. From 1933 through 2007 in the USA, that strategy worked quite well, but there are two problems: 1. We can’t necessarily afford to wait a decade for the market to recover from severe recessions and 2. The strategy doesn’t work at all in indefinite bear markets in declining countries.(see Japan 1989-2009).

If we accept that predicting broad trends is at least useful if not absolutely necessary, what should we try to predict? Some areas of prediction are impossible while others are relatively easy. For example, I think it’s impossible to predict biomedical discoveries over the next decade; science and technology advances suddenly and unpredictably. Much easier to predict are demographics. We know how many 30 year olds live in the UK today, so we have a pretty good idea how many 40 year olds will be in the UK in a decade. Even here there are uncertainties; we have to estimate immigration and can always be surprised by a brutal war or plague. Still, demographic predictions are powerful and reliable. We know that Japan is headed for crisis as its population rapidly ages. The western world is in gradual decline as the number of consumers, workers, and taxpayers falls, and pensioners rise. China may face a crisis in 20 years as a result of its one child policy.

Similar to demographics, investment in infrastructure and human capital yields consistent dividends. For example, South Korea’s investment in education means they will have one of the most highly educated workforces in 10 years. Similarly, we can be sure that the Kenyan workforce won’t be filled with graduate degrees a few years after few Kenyans are attending college.

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