“It’s tough to make predictions, especially about the future.” -Yogi Berra
While Mr. Berra was much more well-known for his exploits on the baseball diamond than his financial acumen, his observations about the difficulties of predicting the future certainly resonate with most corporate executives. Specifically, projecting financial performance requires significant judgment and critical assessment for a variety of “unknown variables”, which makes the process unknowingly susceptible to certain cognitive biases (i.e., “mental shortcuts” or limitations on a person’s consciousness when attempting to analyze possible outcomes) that could significantly limit reliability or effectiveness. Accordingly, one of the first steps in the forecasting process for every organization (even BEFORE the Excel spreadsheets are set up…) should be to take inventory of common forecasting biases and develop safeguards to mitigate their impact. As a starting point, let’s look at two of the most common biases inherent in forecasting financial performance: Recency Bias and Conservatism Bias. Knowing the primary cognitive shortfalls of your company’s forecasting process will go a long way to improving the quality and accuracy of examining what obstacles and opportunities may lie ahead.
The process of forecasting is littered with several potential mental roadblocks that could lower the effectiveness for its primary application: unbiasedly analyze all possible operating and performance scenarios to plan and prepare a company for the future. Warren Buffett articulated the difficulties of forecasting best when he said, “In the business world, the rearview mirror is always clearer than the windshield.” So the next time you or your company finds itself in budgeting season, remember that “getting the future 100% right” is difficult to accomplish, but addressing some common cognitive prejudices may have a profound effect on the quality, reliability, and accuracy of your company’s financial projections.
Written by Scott Williams, CPA
Senior Financial Analyst
Valuation and Financial Services