Extrapolating trends – a word of caution for business owners

Making predictions about the future based on past trends is fraught with danger. What lies ahead is rarely a straight-line extrapolation of historical data. Rather, the path to the future bobs and weaves and zigs and zags as unforeseeable factors almost always intervene.

This is why managed investment schemes warn investors that “past performance is not an indicator of future success”. Numerous studies have failed to find a significant positive correlation between past investment performance and future performance.

In many areas of business and life, history does not repeat itself. Indeed, the future can be quite different from the past. We have all heard stories about people who were down-and-out on their luck but made a determined effort to turn their lives around and became role models for others to emulate.

Yet we typically allocate resources to those who have a track record of achievement and ignore those who have been unsuccessful. History shows, however, that for many people failure is a necessary pit-stop to eventual success as it provides a sobering learning experience.

Both Bill Gates and Steve Jobs had early setbacks in their careers. Before founding Microsoft, Gates experienced failure with Traf-O-Data – a product he created to analyse data from traffic tapes. Likewise, Steve Jobs was kicked out of his own company in 1985 but eventually returned as CEO of Apple and went on to develop the ground-breaking iPod, iPhone and iPad.
While failures can be turned into successes, the opposite is also true. The once mighty Kodak ignored the disruptive threat posed by digital photography and this ultimately destroyed its film-based business model. Other corporate titans, like Blockbuster video and Borders bookstores, also suffered similar fates.

The danger in extrapolating trends can also be seen in the now famous assertion by legendary British economist, John Maynard Keynes. In the 1930’s he witnessed the rise in automated factories and forecast that continued automation would lead to a 15 hour working week by 2030.

As we all know, Keynes got it spectacularly wrong. Despite significant productivity gains over the past 100 years, workers still log an average of 40 hours per week. Consequently, we have not – as Keynes predicted – morphed into a leisure society due to an abundance of spare time.

In fairness, Keynes was correct when he anticipated in 1930 that within a century the standard of living in Western economies would increase significantly. But what he got wrong, according to current day Harvard University Economics Professor, Richard B. Freeman, was the substitution effect (which is the opposite of the wealth effect).

According to the wealth effect, when people get rich, they can afford more leisure time. However, people choose not to work less due to the substitution effect. As Professor Freeman explains: “The more money you earn, the less likely you are to indulge in leisure”. That’s because your time at work is worth more than a lower-income person’s time at work.

Professor Freeman is a contributor to the book, Revisiting Keynes: Economic Possibilities for our Grandchildren. He authored Chapter 9: Why Do We Work More Than Keynes Expected? and believes Keynes overestimated the human desire for leisure, particularly among the rich.

Freeman notes that in the latter half of the 20th century, the inverse relationship between hourly pay and hours worked reversed itself. “The workaholic rich replaced the idle rich. Those earning higher pay worked more hours than those earning lower pay”.

Instead of poorer people working more than wealthier people, the opposite has become true. In his chapter, Freeman asks: “Why did Keynes miss the boat on work?” and provides the following response.

“He missed the boat by failing to appreciate the power of economic incentives to induce people, even those with high standards of living, to work long and hard. He did not expect that the increased cost of leisure due to rising wages would dominate the income effect that induces people to take more leisure. This was nothing peculiar in his expectation. Until the latter part of the 20th century, when it became clear that people were not going to reduce hours greatly as income rose, most economists believed that the income effect was more powerful than the substitution effect”.

Forecasting the future is a mug’s game, yet there is no shortage of “experts” prepared to offer Nostradamus-style predictions. According to Professor Philip E. Tetlock from the University of California, experts’ predictions are no more precise than random guesses as “…experts are about as accurate as dart-throwing monkeys”.

Tetlock has made the study of prediction his life’s work and achieved prominence following the release in 2006 of his seminal book, Expert Political Judgment: How Good Is It? How Can We Know? Tetlock found that “experts” who appear on television, get quoted in newspapers and speak at conferences are no better than the rest of us when it comes to the business of predictions.

From the Y2K hysteria to the fervent belief that the Japanese economy would permanently overtake the American economy in the 1990s, history is littered with examples of seers who got it wrong. Yet, to my amazement, people continue to put great faith in “experts” despite their woeful track record.

Only fools or geniuses try to predict the future – and I’m neither!

John (JT)Thomas

This opinion piece is provided by John (JT) Thomas, a 47-year veteran of the financial services industry and since 1987 a specialist in commercial mortgage funds. Considered by many to be the father of the modern commercial mortgage fund sector, JT helped establish and then managed – for 17 years – what became the largest and most successful commercial mortgage fund in Australia – The Howard Mortgage Trust – with assets exceeding $3 billion. Under JT’s stewardship, investors never lost one cent of their investments and indeed, investors always received competitive monthly returns. JT was also Chair of the $40 billion mortgage trust industry sector working group.

JT has been proudly involved with Princeton for nine years and sits on both the Princeton Credit Committee and the Princeton Compliance Committee as well as being an advisor to the Princeton Board.