I’ve just started reading Nate Silver’s new book The Signal and The Noise (Why so many predictions fail – but some don’t). If you’re looking for something stimulating to read over the Christmas break, this should do the trick. There’s still time to order it.
Nate Silver, (34), is the US’s latest media darling – he has accurately predicted the outcome of several major elections in fine detail. In the race between Barack Obama and Mitt Romney, Silver correctly predicted the winner of all 50 states and the District of Columbia. Now, that’s never been done before.
Here’s an extract from the introduction:
“In The Signal and The Noise, Nate Silver examines the world of prediction, investigating how we can distinguish a true signal from a universe of noisy, ever–increasing, data. Many predictions fail, often at great cost to society, because most of us have a poor understanding of probability and uncertainty. We are wired to detect a signal, and we mistake more confident predictions for more accurate ones. But overconfidence is often the reason for failure.”
So, Silver’s book has got me thinking about our own industry, and the confident predictions that have been made over the last ten years, specifically about the market factors that drive the level of pension scheme deficits. On the whole, I think I can say without fear of contradiction, those predictions have been spectacularly wrong. For the last decade, there has been a general consensus that equities would undoubtedly return 7% year on year, the real yield would rise and peace on earth would be restored.
Anyway, here is my Market Diary blog written seven years ago which my buddy and Co-CEO Rob reminded me of a couple of days ago.
You will realise that back in 2005, we were flying directly into a forecaster's head-wind with the “fanciful” prediction that we would soon see a super-low real yield of 0.17% and, consequently, soaring pension deficits. The general consensus back then, was that the real yield would rise, not fall.
Our predictive reasoning, for what it is worth, wasn't complicated:
The immutable laws of supply and demand are at work. They grind exceeding slow, but exceeding sure. There aren’t sufficient index-linked gilts or swaps for every pension scheme’s needs. As demand goes up, (due to regulation, accounting and too many other factors to go into here), the price will surely rise and the yield will surely fall. This will keep happening for a long time to come. Eventually there will be no real yield at all. Devastation and misery will follow.
I explained it all to my six-year old son:
There are only three bars of chocolate left in the sweets shop. The nice man who owns the shop can put up the price of the chocolate bars whenever he wants to. If all the kids in your class go into the shop and ask for a bar of chocolate, what will the nice man do?
He will put the price up, Papa.
I won't be able to buy any.
To tell the truth, things didn’t move as quickly as we expected. Although the real yield did eventually collapse, it took another four years to fall to 0.17%. When it did, it blew straight through to zero and below. These days, it hovers somewhere around freezing.
Footnote: As my boy observed back in 2005:
Maybe we should go to the shop right now and buy some chocolate before the man puts the price up…?