The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Wednesday, May 16, 2007

The Foresight Saga Revisited (or How Much Money Can You Make If You Had Perfect Foresight?)

So what is the 'Foresight Saga'? The Foresight Saga was a gedanken (i.e., thought experiment) conducted by The Economist magazine in its fin de siecle (1999) Christmas issue. The Economist magazine created an imaginary character named 'Felicity Foresight' who was able to perfectly predict the performance of financial markets -- across different asset classes and across borders -- for each and every upcoming year from January 1st 1900 onwards.

Starting with an initial investment of $1 in January 1st 1900 (and by reinvesting any dividends and/or interest income in the coming years), Felicity Foresight would decide at the beginning of each year which investment would bring the highest return (capital gain plus income) for that year and put all her wealth into that single asset. She would repeat this process year after year, shifting her funds to match her new forecast for each and every year starting from the year 1900.

How did Felicity do? By January 1st 2000, she managed to turn $1 into $1.3 quadrillion even after deducting transaction costs and taxes. Compared to the $9,000 she would have earned had the $1 been invested in a broad collection of American stocks, Felicity Foresight's performance is truly staggering! The last time The Economist checked in on Ms. Foresight (January 2, 2003), her investment acumen more than doubled her portfolio (to $2.7 quadrillion). [Note: All figures in this paragraph are the revised figures from the 2003 article, and not from the original 1999 article.]

In addition to Felicity Foresight, the Foresight Saga also included two ancillary characters (and potential suitors) -- Henry Hindsight and Charlie Contrarian -- that added zest to this tale of predictive perfection. Unlike Felicity, neither Henry nor Charlie were able to perfectly foretell the future direction of financial markets.

Henry Hindsight follows the same investment process that Felicity does with one major exception: Henry invests in the previous year's best performing asset. In other words, Henry Hindsight is like most investors, following 'fashions' and 'trends.' Henry's initial $1 invested at the beginning of 1900 would have only grown to $783 -- much less than either Felicity's portfolio or investing in a broad index of American shares.

Charlie Contrarian, on the other hand, invested in the previous year's worst performing asset (apparently believing in a sort of 'mean reversion'). Charlie did somewhat better than Henry -- turning his $1 into $1,730 in a century of investing -- but not as well as either Felicity or a broad index of U.S. equity.

The following chart lists the investment choices that Felicity Foresight made over the last century (you can click on the image to enlarge it).

Needless to say, no one has perfect foresight. So inventing 'Felicity Foresight' may, at first blush, seem a rather pointless exercise. However, I believe that we can learn a great deal from gedankens / empirical studies like the Foresight Saga.

One of the things we can learn from this thought experiment is that financial experts often underestimate the effects of taxes and transaction costs. If Felicity's porfolio had been constructed without those costs, it would have grown to $27.5 quintillion; i.e., 99.99% of potential investment wealth was eliminated by transaction costs and taxes (along with effects of compounding). Many experts tend to think of these kinds of costs to be negligible and readily dismiss them, but this extreme example demonstrates that investment costs can add up -- or, more precisely, compound -- to a sizable amount in the long run.

Another valuable lesson that can be learned from this seemingly fanciful tale is that there has been a fundamental change in the ability to achieve investment performance over the last decade and a half. Until the early 1990s, both Henry Hindsight's and Charlie Contrarian's strategies -- which are the typical strategies used by most investors -- would have led to respectable gains. Since then (or at least until the early 2000s), these strategies would have been less successful and, up until the year 2000 or so, would have led to substantial losses.

What is the nature of this 'fundamental change' over the last decade and a half or so? Could it be a more globalized financial market where poor performance in one part of the globe or in one asset class can reverberate much more readily than prior to the 1990s? Could it be that a more dynamic marketplace has shortened the time frame and/or reduced the opportunities where either of the two traditional investing strategies can profit?

One final lesson that can be learned from the Foresight Saga is that the creator(s) of the story have shown that they -- unlike Felicity, but like the rest of us -- lack perfect foresight. None of the installments of the Foresight Saga (the last one was in January 2003) foresaw with any detail what has happened since then and no one could have profited at the rate that Felicity did by what they could glean from her tale of investment success.

Despite the lack of useful predictions for the future, I do hope that The Economist revives the Foresight Sage in the near future because of the insight that this gedanken gives us about the past's future. What do I mean by the 'past's future'? What I mean by that is that we can use the Foresight Saga -- not as a way to give us perfect foresight (which it doesn't) -- but as a way to put ourselves in the proverbial shoes of those who in the past had been trying to make decisions based on uncertain projections of the future. In other words, we can evaluate the past's predictions about the future ... and see the frustrating nature of such attempts at prediction. For example, anyone who had predicted in 1939 (the eve of World War II) that, by the early 1940s (well into World War II), the French stockmarket would have over a 200% annualized return would have been dismissed as a lunatic ... yet it happened!

The Foresight Saga is more about hindsight than foresight ... gendankens and empirical studies like this one can place us back in time to see how those who came before us (or even ourselves in the distant past, if we are old enought) viewed their future ... and usually got it wrong! The most important lesson to learn from Felicity Foresight's amazing track record as an investor is how all of us, in reality, lack such consistently perfect foresight about our future.

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