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The Next Big Thing...

The Next Big Thing...

Do you think you are capable of predicting the future? Before answering with a simple yes or no, take a moment to appreciate that fact that it is actually a very nuanced question.

Say, you are an astronomer. You study and observe space objects. You calculate their velocity, orbit, and trajectory. You know with a great mathematical precision where each of these space objects will be at any specific time. Can you predict the future? Hell, yes!

Say, you are a meteorologist. You study climate systems. You observe weather patterns, air fronts, and cyclones. You calculate and predict the weather based on historical patterns and current anomalies. Can you predict the future? Only partially. As we all know, weather forecasts are generally good but far from perfect.

Say, you are an economist. You study global macroeconomic developments. You observe and collect a wealth of economic indicators. You use those to estimate the stage of the current business cycle and translate that into expected asset returns. Can you predict the future? Take a look at the below chart and decide for yourself:

Source: AQR Capital Management, Consensus Economics, Bloomberg

Naturally, the question you may be asking yourself is why. Why are economists (and investors for that matter) unable to predict the future while professionals like astronomers and meteorologist are apparently much better at it? Are economists less educated, less capable, or simply lazier? No, no, and no.

You see, it all boils down to the environment that you may be trying to predict. A useful way of thinking about it is in terms of a signal-to-noise ratio. The movement of space objects is a system with extremely high signal-to-noise ratio, which in turn allows for the great mathematical precision of astronomers’ forecasts. Climate and weather have a decent (albeit lower) signal-to-noise ratio, which is the reason why meteorologists’ weather forecasts are reasonably good but not perfect. Financial markets and the global economy, on the other hand, are completely different animals.

Because financial markets represent the constant interaction of humans - with their idiosyncratic decisions, behavioral and cognitive biases - the signal-to-noise ratio is very poor. So, don’t blame the economists for their lack of accuracy – this is literally the best they can do given the environment they operate in and try to predict.

If it’s so difficult to predict the future market returns, why bother at all? – you may be asking. We couldn’t agree more with you. Rather than spending futile efforts in predicting the unpredictable, isn’t it more sensible to deploy a strategy that is literally built on the concept that the future is unpredictable? A systematic strategy that is non-directionally biased and greatly diversified? A strategy by the name of Trend Following?

You see Trend Followers are humble and know exactly what they can and can’t predict. They know that in low signal-to-noise ratio environments, the best answer to the question “how is the future going to pan out?” is a simple “I don’t know”.

Which brings us to this week’s episode of the Systematic Investor podcast series which featured Rob Carver. Rob – a Trend Follower by heart – was asked to identify what will be the next big investment approach that hardly anyone talks about today but will be huge in 30 years. Correctly recognizing that the question requires a forecast about an environment with extremely low signal-to-noise ratio (i.e., the real world), Rob humbly and honestly admitted that he simply doesn’t know.

There is a lot of power and wisdom in being able to recognize what you can and can’t predict. If you are interested in finding our about what else did Rob have to share, feel free to tune into this week’s episode of the Systematic Investor podcast series.

As usual, we promise your time will be well spent!