Why Forecasts Differ
and
Why are they so Bad?
Roy Batchelor
Professor of Banking and Finance,
Cass Business School
But back in the real world…
• Forecasters often look (and feel) stupid
• This is because
Sometimes they can’t help it.
Sometimes they deliberately make biased forecasts.
• Aim is to separate these causes of error, using evidence from
panels of forecasters
Consensus Economics
Blue Chip Financial Forecasts
• Payoff – which forecasters are worth listening to, and when?
Plan of lecture
• Insights from recession forecasts
• Reasons for biased forecasts
• Who is most biased?
Forecasting the 1991 recession
4.0
Consensus
3.0
Mr. Brightside 1
Dismal Scientist 1
2.0
HMT
1.0
0.0
-1.0
-2.0
-3.0
Jan
Feb Mar
Apr May Jun
Jul
Aug Sep Oct
Nov Dec Jan
Feb Mar
Apr May Jun
Jul
Aug Sep Oct
Nov Dec
1990 1990 1990 1990 1990 1990 1990 1990 1990 1990 1990 1990 1991 1991 1991 1991 1991 1991 1991 1991 1991 1991 1991 1991
Forecasting the 2009 recession
4
3
Consensus
2
Mr. Brightside 2
Dismal Scientist 2
1
HMT
0
-1
-2
-3
-4
-5
Jan
Feb Mar
Apr
May Jun
Jul
Aug Sep
Oct
Nov Dec
Jan
Feb Mar
Apr
May Jun
Jul
Aug Sep
Oct
Nov Dec
2008 2008 2008 2008 2008 2008 2008 2008 2008 2008 2008 2008 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009
Should we privatise GDP forecasts?
• “Ageing model leads Treasury astray”
(Sunday Times 9/2/92)
• “Time to take forecasting away from the Treasury”
(Sunday Times, 12/4/92).
• What do you think?
Forecasts for 1990
3
2.5
2
Consensus
Mr. Brightside 1
1.5
Dismal Scientist 1
HMT
1
0.5
0
-0.5
-1
Jan
Feb Mar
Apr
May Jun
Jul
Aug Sep
Oct
Nov Dec
Jan
Feb Mar
Apr May Jun
Jul
Aug Sep
Oct
Nov Dec
1989 1989 1989 1989 1989 1989 1989 1989 1989 1989 1989 1989 1990 1990 1990 1990 1990 1990 1990 1990 1990 1990 1990 1990
Forecasts for 2008
3
2.5
2
1.5
Consensus
Mr. Brightside 2
Dismal Scientist 2
1
HMT
0.5
0
-0.5
Jan
Feb Mar
Apr
May Jun
Jul
Aug Sep
Oct
Nov Dec
Jan
Feb Mar
Apr May Jun
Jul
Aug Sep
Oct
Nov Dec
2007 2007 2007 2007 2007 2007 2007 2007 2007 2007 2007 2007 2008 2008 2008 2008 2008 2008 2008 2008 2008 2008 2008 2008
Forecasts for 2010: … it’s too soon to know
2
1.5
1
0.5
Consensus
Mr. Brightside 2
0
Dismal Scientist 2
HMT
-0.5
-1
-1.5
-2
Jan
Feb Mar
Apr
May Jun
Jul
Aug Sep
Oct
Nov Dec
Jan
Feb Mar
Apr May Jun
Jul
Aug Sep
Oct
Nov Dec
2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2010 2010 2010 2010 2010 2010 2010 2010 2010 2010 2010 2010
Recession forecasts in general
• Loungani, P, 2001, How accurate are private sector forecasts? Cross-country
evidence from consensus forecasts of output growth, International Journal of
Forecasting, 17, 419-432
Stylised facts about Forecasts
• It’s hard to forecast recession. These are rare events, always
with different causes.
• Consensus forecast usually starts close to the average growth
rate, and then adjusts
• Accuracy-improving information arrives only about 12-15
months in advance of the end of the target year.
• Individual forecasts are distributed above and below the
consensus in a consistent way. There are persistent optimists
and pessimists.
Plan of lecture
• Insights from recession forecasts
• Reasons for biased forecasts
• Who is most biased?
Reasons For Bias
• Incompetence (unlikely, really…)
• Bias in the Consensus:
Learning about Structural Breaks
Market Incentives for Bias
• Bias in Individual Forecasts
Market Incentives for Product Differentiation
Learning about Structural Change
• Important
• Many countries (Japan, Germany, Italy, France) experienced
slowdown in trend growth
• Optimal forecast will be biased to optimism as forecasters learn
about the new trend
• Evidence supports this - forecasts in US, UK less biased
US – Log(GDP) and Forecast (Non-) Bias
Italy – Log(GDP) and Forecast Bias
Market incentives for bias
• Important for Investment Analysts
• Bias to optimism in earnings forecasts can arise from
Selection of firms/ sectors you believe in
Relationship building
Trade generation
• However, regulatory changes (Sarbanes Oxley) can change
incentives…
• May also apply to some government forecasts
Financial analysts: Bias to optimism 1990-2003
Financial analysts: Bias to pessimism 2003-
Dispersion v Herding in Individual Forecasts
• There is evidence of herding – excessive convergence on the
consensus – for financial analysts
• However, there is evidence of the excessive dispersion of
forecasts by economic forecasters, who
underweight information in the consensus forecast (Batchelor
and Dua, 1992, J Forecasting )
Maintain consistently optimistic or pessimistic priors from year
to year (Batchelor and Dua, 1990, Int J Forecasting;
Batchelor, 2007, Int J Forecasting)
Herding
• Financial forecasters have incentives to overweight consensus
forecasts:
“Information cascade”: forecasts are made sequentially, so
each forecast becomes part of the next forecasters prediction
set. In aggregate published forecasts are biased towards the
early forecasts.
“Incentive concavity”: rewards for an accurate “bold” forecast
are smaller than penalties for an inaccurate bold forecast. Less
experienced forecasters herd more since career prospects are
at stake.
Dispersion and Product Differentiation
• Hotelling “location model” – don’t set up your store right next to
everyone else, but don’t be too far out of town. So profit
maximising strategy is to shade forecasts consistently away
from the Consensus (even if you believe it is the best forecast)
• Batchelor and Dua (1990), Batchelor (2007) find individual
forecasters persistently make optimistic or pessimistic forecasts
relative to the consensus. Interpreted as an attempt to
differentiate their product, increase press coverage, book sales,
speaking fees etc.
• Does not harm accuracy, except in extreme cases
Evolution of Forecast Disagreement
• Lahiri, K., and X Shen, 2008, Evolution of Forecast Disagreement in a
Bayesian learning Model, Journal of Econometrics, 144, 325-340.
News and Dispersion of Forecast Revisions
• Forecasts converge, but quarterly GDP releases give
forecasters an opportunity to put different spins on the figures
Plan of lecture
• Insights from recession forecasts
• Reasons for biased forecasts
• Who is most biased?
Blue Chip Financial Forecasts
Method
• Forecasts from US Blue Chip Financial Forecasters
TB3, TB30, RGDP, CPI,
1983-1997 (+ updating), Horizons 15 mths – 1 mth
• Questionnaire on Forecaster Characteristics
Sent to 80 BCFF participants, Nov 1993 - Jan 1994
43 useable responses
25 with full track record.
Ranking by Forecast Quality
For the 25 forecasters, we compute average (over horizon) ranks
for each target variable by
• Bias (actual-forecast, low rank = overprediction)
• Extremism (absolute deviation from consensus forecast, high rank
= far from consensus)
• Accuracy (RMSE, low rank = high accuracy)
• Calculate Rank Correlations with Forecaster Characteristics
Individual Characteristics
Please provide the following information about you and your
organisation:
Type of Organisation:
Location:
Highest College Degree (tick): Bachelors  Masters  PhD 
Number of years experience in forecasting
Percentage of work time spent in forecasting
Number of staff involved in forecasting at your organisation
Individual effects: Rank Correlations
Bias
TB3
FBANK
FNYDC
FDEG
FYRS
FPERCENT
FNOS
-0.33
0.13
0.44
-0.17
0.17
-0.06
TB30 RGDP
-0.36
-0.18
0.29
-0.27
0.02
-0.11
-0.27
0.15
-0.12
0.24
0.09
-0.18
CPI
-0.04
-0.06
0.05
-0.56
-0.08
-0.02
Extremism
TB3 TB30 RGDP
-0.35
0.20
0.06
0.29
0.19
0.21
-0.43
0.12
-0.11
-0.08
0.20
0.19
-0.16
-0.07
-0.16
0.28
-0.02
-0.31
CPI
-0.32
0.01
0.21
0.15
0.27
-0.14
Accuracy
TB3 TB30 RGDP
0.12
0.04
-0.38
0.22
0.08
-0.01
-0.10
0.02
-0.17
0.19
0.18
0.01
-0.32
0.07
0.12
0.19
0.31
-0.19
CPI
-0.12
-0.04
0.05
0.32
0.12
-0.22
• Banks made higher, less extreme, more accurate GDP forecasts
• Experienced forecasters made slightly more extreme forecasts of
TB3, RGDP, but no convincing evidence of extremism
• Location, education, attention, size of team not significant
Clientele
Please indicate the relative importance of the following groups
as users of your forecasts (weights should add to 100):
Traders inside your organisation
Other colleagues inside your organisation
Clients of your organisation
General public
Other
Concentration measures
• We have constructed measures of concentration of
Clientele, Technique, Theory and Information weights
A forecaster who only served external clients would have
a high concentration measure (UCONC)
A forecaster who put equal weight on all types of user
would have a low concentration measure
• Hypothesis is that low concentration may reduce extremism
and improve accuracy
Strong Clientele Effects
Bias
TB3 TB30 RGDP
CPI
UTRADERS -0.42 -0.42 -0.13 -0.30
UINTERNAL -0.05 -0.12 -0.33 -0.14
UCLIENTS
0.33 0.36
0.26 0.36
UPUBLIC
-0.12 -0.04 0.11 -0.11
UOTHER
0.20 0.13 0.26 -0.24
UCONC
0.21 0.24 0.21 0.36
Extremism
TB3 TB30 RGDP
-0.29 -0.20 -0.36
-0.26 -0.52 -0.12
0.45 0.54 0.35
-0.36 -0.29 -0.23
0.07 0.07 0.18
0.36 0.47 0.38
CPI
-0.17
-0.18
0.21
-0.10
0.32
0.22
Accuracy
TB3 TB30
0.38
0.06
-0.34 -0.41
0.02 0.25
-0.18 -0.04
-0.06 0.02
0.16 0.26
RGDP
-0.32
-0.34
0.48
-0.30
0.27
0.49
• Forecasters giving weight to traders, internal users, or public,
made less extreme and more accurate forecasts
• Forecasters with external clients made more extreme and less
accurate forecasts
• Concentration on one type of client also increases extremism
CPI
-0.12
-0.13
0.21
-0.28
0.16
0.23
Forecast Techniques
In making forecasts of US interest rates 3 to 6 months ahead, what
weight do you assign to the following forecast techniques:
(weights should add to 100)
Econometric Models (structural, regression)
Time Series Models (Box Jenkins, ARIMA, VAR)
Exponential Smoothing methods
Technical Analysis (Chart Analysis)
Judgment
Other
Also give weights for forecasting 1 year ahead and beyond, if
different.
Weak Technique effects
Bias
TB3 TB30 RGDP
TECHSEC
-0.03 -0.02 -0.36
TECHSTS
-0.26 -0.45 -0.34
TECHSSM
-0.02 -0.20 0.14
TECHSTA
-0.25 -0.22 0.23
TECHSJT
0.23 0.30 0.34
TECHSOTH
0.09 0.08 0.10
TECHSCONC 0.28 0.34 0.42
CPI
0.09
-0.29
-0.31
-0.26
0.20
0.07
0.27
Extremism
TB3 TB30 RGDP
0.21 0.29 -0.39
0.28
0.06 -0.17
-0.14 0.00 0.09
-0.19 -0.15 0.00
-0.16 -0.17 0.50
-0.21 -0.15 -0.26
-0.19 -0.12 0.33
CPI
0.01
-0.14
0.17
0.01
0.16
-0.26
0.24
Accuracy
TB3 TB30 RGDP
-0.15 0.07 -0.20
0.09 0.09 -0.14
-0.31 -0.28 -0.03
0.08 0.03 -0.18
0.06 -0.01 0.38
0.15 -0.25 -0.05
0.16 0.10 0.41
CPI
0.02
0.16
0.00
-0.14
0.11
-0.47
0.19
• Smoothing methods are associated with higher accuracy, but little
used
• Use of Judgement, and Concentration on one technique increased
extremism and reduced accuracy of real GDP forecasts
Theory
If you use Econometric Models, what weight do you put on the
following types of economic theory: (weights should add to 100)
Keynesian
Monetarist
Rational Expectations
Supply Side
Business Cycle
Other (specify)
Some Theory effects
Bias
TB3 TB30 RGDP
THKEYNES
0.33
0.34
0.26
THMONET
0.21 0.33 -0.40
THRATEX
-0.23 -0.11 -0.64
THSUPSIDE
-0.24 -0.06 -0.12
THBUSCYC
-0.12 -0.34
0.46
THOTH
0.02
0.05 -0.10
THCONC
-0.25 -0.31
0.41
CPI
0.06
0.46
-0.10
0.12
-0.36
0.25
-0.26
Extremism
TB3 TB30 RGDP
-0.01
0.12
0.06
-0.47 -0.43 -0.07
0.13
0.07
0.21
0.23 -0.04 -0.03
0.15
0.18
0.05
-0.19 -0.14 -0.48
-0.22 -0.02 -0.01
CPI
-0.33
0.27
0.28
-0.04
-0.08
0.11
-0.10
Accuracy
TB3 TB30 RGDP
-0.13 -0.17 -0.04
-0.33 -0.24 -0.19
-0.05
0.14
0.00
0.05 -0.01
0.09
0.26
0.16
0.14
0.02
0.07 -0.14
0.44
0.22
0.09
• Keynesians made low forecasts of interest rates
• Monetarists made low forecasts of interest rates, inflation, high
forecasts of real growth. Business Cycle theorists had the
opposite biases
• RE theorists made consistently high forecasts of real growth
• Few differences in forecast accuracy, however
CPI
-0.46
-0.01
0.24
0.07
0.22
-0.16
-0.01
Judgment
If you use Judgment, what weight so you place on the following
processes? (weights should add to 100)
Own analysis of current event
Group analysis within your organisation (meetings, surveys)
Other (specify)
Some Judgment Process effects
JTOWN
JTGROUP
JTOTHER
Bias
TB3 TB30 RGDP
CPI
0.21 0.47 0.30
0.23
-0.08 -0.36 -0.30 -0.12
-0.33 -0.41 -0.15 -0.30
Extremism
TB3 TB30 RGDP
0.00 0.19 0.01
-0.17 -0.27 -0.03
0.28
0.03 0.02
CPI
0.26
-0.20
-0.22
Accuracy
TB3 TB30 RGDP
0.25 0.22 0.16
-0.38 -0.39 -0.13
0.09 0.18 -0.12
• Some evidence that group processes improve accuracy of interest
rate forecasts, reliance on own judgment harms accuracy
CPI
0.02
-0.07
0.07
Information
If you use Judgment, what weight so you place on the following
pieces of information? (weights should add to 100)
Current Official Economic Statistics (GDP, Inflation, …)
Forecasts made by other organisations (e.g. Blue Chip Financial
Forecasts)
Surveys of Consumer and Business Confidence
Other (specify)
Strong Information Source effects
Bias
TB3 TB30 RGDP
INFONEWS
0.06 0.14 0.01
INFOFORCS
0.06 -0.11 -0.28
INFOSURV
0.13 0.11 0.08
INFOOTH
-0.14 -0.09 0.12
INFOCONC
-0.04 0.09 -0.03
CPI
0.28
-0.24
0.15
-0.15
0.16
Extremism
TB3 TB30 RGDP
0.11 0.23 -0.04
-0.26 -0.16 -0.10
0.09 -0.13 0.07
0.02 -0.03 0.06
0.24 0.27
0.00
CPI
0.04
-0.01
0.02
-0.03
0.07
Accuracy
TB3 TB30 RGDP
0.19 0.30
0.15
-0.45 -0.36 -0.51
-0.08 -0.15 -0.14
0.15 0.03 0.25
0.28 0.36 0.33
CPI
-0.10
-0.07
-0.14
0.18
0.12
• Forecasters who place a lot of weight on the forecasts of other
forecasters are less extreme, and significantly more accurate on
interest rate and real GDP forecasts
• Forecasters who rely heavily on one source of information tend to
be less accurate
Who should you listen to?
• Less extreme
 work in bank
 serve general public
• More accurate
 serve general public
 use any theory
 … except RE
 pay attention to other
forecasters
• More extreme
 rational expectations theory
 listen to friends, boss
 overweight news
• Less accurate
 limited range of users
(e.g. only external clients)
 doctrinaire use of theory
(e.g. only Monetarism)