It was pounded into our heads in a statistics class that an estimate without some measure of its variability is useless. In the context of investment decision making knowing that a company is expected to earn $1 this year or the stock market is estimated to return 10% a year are not informative without some sense of how far off these estimates might be.
One well documented way to generate a range of estimates is to utilize scenario thinking. Jay Walker at the Confused Capitalist has been doing some reading on the subject of scenario generation and risk management. He notes a number of forecasts that in retrospect were ridiculously short-sighted. The challenge for investors is to think about the entire range of possibilities, large and small.
…By laying out a number of different possibilities – some perhaps even seemingly far-fetched, it allows us to better consider the risk/reward potential of an investment.
By doing so, we avoid the blind reliance on the “most likely” forecast, and to therefore protect ourselves to some degree against other, seemingly obscure, possibilities.
Scenario thinking – worth considering in your own investing.
The post is well worth reading and will make you think. All of this reminds of a famous quote by noted physicist Niels Bohr.
Prediction is very difficult, especially about the future.