Five Steps To Becoming A Market Superforecaster

Five Steps To Becoming A Market Superforecaster
Stéphane Renevier, CFA

over 2 years ago5 mins

  • You need to start out by defining what you actually want to forecast, and then break the problem down into its component parts.

  • Then you need to find the right balance between the cold, objective “outside view” and the more emotion-led “inside view”.

  • And finally, you need to be willing to both adjust your forecast when new information arises and admit when you’ve gone wrong.

You need to start out by defining what you actually want to forecast, and then break the problem down into its component parts.

Then you need to find the right balance between the cold, objective “outside view” and the more emotion-led “inside view”.

And finally, you need to be willing to both adjust your forecast when new information arises and admit when you’ve gone wrong.

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You’re a human prone to behavioral biases, so it’s only natural that you’d have an instinctive, emotional response to a headline like markets are significantly overvalued and about to crash”. But as Philip Tetlock points out in “Superforecasting: The Art And Science Of Prediction”, a superforecaster takes a very different approach to estimating what’s yet to happen – and I’ve distilled that approach into five steps you could apply to the financial markets.

Step 1: Define what you’re trying to forecast

First things first, you need to understand what “markets are about to crash” actually means. Which markets are we talking about? What percentage loss counts as a crash? And over what time horizon? To predict the accuracy of this statement, we first need to define what exactly we’re predicting. So in this case, we could for example rephrase the problem as: “What is the probability that the S&P 500 will be down more than 10% in one year’s time?”

Try to have a guess before reading on.

Step 2: Break the problem down

To work out the probability of this statement, you need to recognize that it’s made up of a couple of component parts.

Let’s zoom out for a second. If someone were to ask you to estimate the number of piano tuners in Chicago, you’d want to figure out how many pianos there are in the city, how many pianos are tuned each year, how long it takes to tune a piano, and how many hours a year the average piano tuner works. The idea is that by simplifying this problem into smaller, more manageable bits, we can pretty quickly formulate a surprisingly accurate forecast.

There are two parts to the original statement: markets are significantly overvalued and about to crash”. So there are actually two elements we could try and analyze: the probability that stocks are “about to crash”, and the probability that stocks crash when we know they’re overvalued. While what we’re really trying to forecast is the former, we’re also going to need to look at the latter.

Step 3: Strike the right balance between “inside” and “outside” views

Tetlock discovered superforecasters see things in two ways: “inside views” and “outside views”.

They start by posing an “outside view” question: that is, they aim to remove emotions and look at cold, objective, hard data. So they want to know how often outcomes of this sort happen in situations of this sort by looking at the facts. Going back to our market example, we could look at the percentage of time the S&P 500 lost more than 10% over a one-year period, which has only happened 15% of the time since 1996.

The trouble is, this case ignores important information that makes this situation somehow “unique”. A unique factor might, in this instance, be how high valuations are right now. If you take those valuations into account by looking at the relationship between forward P/E ratio and subsequent one-year returns (the left hand side of the chart below), the probability of a 10% loss increases to 30%.

Stock valuation vs subsequent returns
Stock valuation vs subsequent returns

It does bear pointing out, however, that the relationship is quite weak and there’s an almost equal amount of times stocks ended up much higher. So an estimated range for the “outside view” probability is actually around 15% to 30%.

Now of course, no situation can’t be fully summarized by a number. Looking at the potential impact from a default of Evergrande, or a potential change in the US Federal Reserve language, requires judgment. This part of the analysis – using your judgment to assess the specifics of the particular case – is what Tetlock calls the “inside view”.

But there are two problems with the inside view: first, it’s prone to biases, since it depends on the main market narrative and is driven by things like what’s been heavily presented in the news recently. Second, our brain is naturally biased to the inside view: it’s often filled with engaging details and it’s easier to make a good story out of it.

To combat those biases, Tetlock explains it’s important to use your “outside view” as your main anchor and use your “inside view” to adjust it. In our example, the 15% to 30% probability is our outside view, so even if our inside view assessment is quite negative, it’s unlikely we’re going to give an emotionally driven overestimate. The probability, then, is perhaps going to be 30% or 40%, but unlikely to be as high as 80% or 90%, as the original news article suggested.

One of the reasons market commentators have predicted so many crashes that haven’t materialized is that they’ve overweighted their emotionally driven inside view over the cold, hard outside view. Using the outside view as an anchor would’ve fixed that.

Step 4: Update your forecast frequently

Tetlock found that superforecasters update their forecasts much more frequently than regular forecasters. In other words, if the facts change, so should your forecast.

For example, whatever your original probability was before the whole Evergrande debacle cropped up, it should be adjusted now we know it could collapse and take Chinese stocks down with it. The best forecasters aren‘t married to their view, and they’re willing to significantly change their forecasts even if it means contradicting their own previous thesis.

I think this is what makes investors like Georges Soros and Ray Dalio so successful: they constantly attempt to understand where they could be wrong and care more about making money than being right. When the facts change, so should your forecast – even if it means making a 180 degree turn.

Step 5: Learn from your mistakes

If you had to guess the one quality you think Tetlock says that makes a superforecaster, what would it be? Intelligence? Nope, he found one quality roughly three times as powerful as that: a relentless commitment to updating your beliefs and focusing on self-improvement. That means spending time analyzing your failures and successes alike, focusing on what you got right (or wrong) and what you could’ve done differently.

So if you’re keeping a score of all your trades and constantly trying to figure out what you could have done better, then congratulations – you’re probably already on the right track.

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