Financial Forecasting: Why it is still about being roughly right than precisely wrong

Paradoxically and fatally, just when risk of a downturn is at its highest, optimism also ends up peaking! So be careful with your forecasts; and even more careful with the forecasts of others.

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What goes into making sensible forecasts?
Business Planning is one of the most critical functions for a business, irrespective of size, and forecasting is an essential part of this. Any business owner would need to make financial forecasts in order to identify many aspects - hurdles or bottlenecks for growth, amount of cash availability, value of the business, capital requirements, etc.

Investors and lenders too would demand reliable financial forecasts in order to provide capital. Quite correctly then, financial forecasting should take up a lot of serious and sensible effort by the business owner.

So, what goes into making sensible forecasts? To answer this important question, let's look at it the other way around- what is the usual approach followed, which makes for a poor forecast.


Assuming the future is known
The underlying assumption in forecasting is that the future is predictable. After all, no one likes to plan for the future while assuming that the future is largely unknowable. Yet, most people would agree that it is impossible to know for sure. Even the most likely events have a probability of occurring and when they do occur, we do not tend to think of all the alternative histories (as Nassim Nicholas Taleb calls them in Fooled By Randomness) that could have occurred, which would've rendered our forecast completely wrong.

Prediction, hence, is a difficult task especially when it comes to the future. If our starting point is that we can't know the future, and perhaps even that we don't need to know it, then we can approach forecasting methodically and mathematically considering a range of possibilities and probabilities for each of them.

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Extrapolating the past and present
If prediction is a difficult task especially when it comes to the future, predicting the past is actually very easy. This might sound like an oxymoron, but fact is that most predictions end up just extrapolating a trend from the past. It is so simple to assume:

- What has happened in the past is the most likely outcome
- The most likely outcome is the only one that will happen
- Improbable outcomes aren't worth thinking about

If the business has been growing at 5% over the last few years, the same rate will be assumed for the coming years with minor variations accounting for capacities, some inherent optimism, and other specific factors. But, how often does the future mimic the past, especially in the volatile business, regulatory, and geopolitical environment we operate in today? Given this constraint, making forecasts using the past trend is like driving forward while looking in the rear-view mirror.
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The pursuit of precision
When it comes to forecasts, business plans, and financial models, precision is coveted. The thoroughness of having looked into and modelled every input minutely makes the forecast look more scientific and well thought out. However, the complexity and precision of the forecast usually ends up concealing the absence of a critical perspective or even common sense.

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On forecasting, Warren Buffett, the high priest of investing, is fond of saying that he would rather be approximately correct than precisely wrong. His forecasting tools? A notepad and pencil, a simple calculator, and a razor-sharp mind that probably understands risk better than any else's. Not even a computer! And no spreadsheets!

Not respecting business cycles
Business and growth cycles usually end up suffering a large jolt every decade or so. Immediately before this, optimism is usually at its peak and forecasts assume that the high growth rates of the past will continue forever. The usual justification comes in the form of the four most dangerous words in the world of predictions: "This time it's different!"

Why do people fall for this trap when cycles always repeat themselves almost metronomically? One reason is that faded memories of the last downturn create a complacency and false sense of security. Hence, paradoxically and fatally, just when risk of a downturn is at its highest, optimism also ends up peaking! So be careful with your forecasts; and even more careful with the forecasts of others.

Lack of review and learning
Beyond the above factors, one of the major pitfalls of the financial forecasting process is the lack of serious review and introspection. How often have you seen forecasters open up their predictions to scrutiny after the event? Forget review by others, forecasters usually do not even self-evaluate their work. In the process, they end up refusing to learn from mistakes and snub the opportunity to do better next time.

The standard tools of financial forecasting such as a working knowledge of financial statements, accounting and cash cycles, and technical knowledge of spreadsheets are definitely essential. However, there is no substitute for a deep understanding of your business drivers and common sense.

While this may sound like predictions are a waste of time since the future is not knowable, it is far better to acknowledge these limitations and accommodate them rather than deny and forge ahead.
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