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Financial strategy - forecasting issues

Finance directors and businesses as a whole consider the probable future to identify trends and better enable decision makers to address any matters now which may arise. An interesting aspect of forecasting is that few remember excellently accurate forecasts, but people always remember bad ones and for some forecasting errors never go away (cf. Michael Fish and the 1987 storms).

One important aspect about forecasting is that one should not apologise when the outcome varies hugely from the forecast  – one of Carl Emmerson’s practical tips within this report – as you can’t be responsible for outcomes outside your control. The number and uncertainty of the variables involved in most forecasting models mean that long range forecasting can offer no more than an idea of trends.

Forecasting can be distracting for business – potentially diverting attention away from more urgent issues and forcing management and boards to focus on potential outcomes which may never materialise. Forecasting should enable business to protect themselves against downturns by identifying areas of risk and trending costs and profits in plenty of time to take remedial action. However, businesses and projects do fail and sometimes spectacularly, e.g. Eastman Kodak and the Eurofighter project.

A paper written by Dan Lovallo (University of New South Wales) and Daniel Kahneman (Princeton University) in 2003, Delusions of Success, highlighted that business is not undermined by rationale decision making in an uncertain world, as classic economic theory might indicate. They argue that project failure and business failure are down to executives’ delusional optimism, ‘spinning scenarios of success while overlooking the potential for mistakes’, a predication for self-delusion and an inflated belief in their own talents caused by a run of luck.

Humans are naturally optimistic – ‘optimism bias’ is seen in 80% of healthy individuals (although Strunk, Lopez and DeRubeis (2006) showed that depressed individuals bias towards unrealistically negative outcomes). ‘Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events’ (Sharot, 2011).

Interestingly, many believe that overall, this optimism bias is good for humanity, even if it is bad for some businesses. Varki, in his paper Human Uniqueness and the Denial of Death (2009), postulated that human evolution depends on it. Staying positive and being optimistic is good for you, but perhaps we should take our forecasts with a pinch of salt.

We hope that you enjoy reading this report and hope that all your forecasts are within range!

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