The Role of Probability and Chance in Financial Forecasting

Financial forecasting is very useful for businesses, as it allows them to plan production, financing and so on. It is not unusual to hear a company's management speak about forecasts: "Our sales did not meet the forecasted numbers," or "we feel confident in the forecasted economic growth and expect to exceed our targets." In the end, all financial forecasts, whether about the specifics of a business, like sales growth, or predictions about the economy as a whole, are informed guesses.

Probability calculations are used frequently in financial forecasts. By collecting historical data and determining the mean and standard deviations, you can estimate the likely range to any percentage of probability you like. You might say that there is a 68 percent probability of dropping by 1 to 2 percent or a 95 percent probability that it will drop between 0.8 to 2.2 percent.

However, financial forecasts can be wildly unpredictable as the data is always going to be old. Historical data is all we have to go on and there is no guarantee that the conditions in the past will persist into the future. It is also impossible to factor in unique or unexpected events, or externalities. Assumptions are dangerous, such as the assumptions that banks were properly screening borrowers prior to the subprime meltdown. The two things that are most commonly used to predict movements are past earnings and price. These two items as predictors is completely insane because both tend to be too volatile and too easily manipulated to be useful indicators. So what are good indicators? There's a joke that's passed around by American economist Paul Samuelson, which says, "The market has predicted eight of the last five recessions."

Adapted from

The Basics Of Business Forecasting. By Andrew Beattie.

Use Statistics and Probability to Make Financial Forecasts. By Michael Taillard.

The Role of Probability in Analyzing Financial Data. By Michael Taillard.