Understanding Uncertainty

An important part of investing is understanding uncertainty – that we do not know what will happen. And yet, at the same time, we must remain optimistic. We must use our knowledge of our lack of knowledge to focus on the opportunities that uncertainty creates.

A 2013 scientific paper (“Managerial Miscalibration”) studied forecasts made by Chief Financial Officers (CFOs) of leading companies, about the stock market. These highly qualified executives were asked to provide 80% confidence intervals for their predictions. (If you think that the stock market has only a 10% chance of returning more than 25% and only a 10% chance of returning less than 5%, then your 80% confidence interval is 5% to 25%.) The authors found that the actual stock market return fell within the CFOs’ confidence intervals just 36% of the time. The interesting aspect of the study is not that the CFOs weren’t able to predict the market return – that is too difficult, even for these highly trained individuals. It is that they had the option of giving a wider interval and they did not. These top executives were too confident about their predictions. A Nobel prize-winning economist (Richard Thaler) asked the paper’s authors, what confidence interval should a rational person, who knows she doesn’t know, provide? The authors told the economist that it should be around -10% to +30% (S&P 500). In practice, if you gave this wide a range as your 80% confidence interval, most people would not consider you an expert on the subject.

At Shepherd’s Hill, we try to remind ourselves that we don’t and cannot know many things. It frees us to focus on specific details, company fundamentals, and micro-economic factors.