“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.
- Recency Bias – Recency Bias (also commonly known as recallability bias) is the tendency to disproportionately weight more recent events or to overreact to contemporaneous business conditions when projecting financial performance. Recency Bias involves overly dramatizing negative information or being overly consumed with strong recent performance when the company’s long-term growth trajectory or earnings potential has not changed. A manager’s skewed pessimistic view of her company’s future performance after following continuous news coverage on the rocky capital markets and global growth concerns through the first two months of 2016 is a timely example of Recency Bias in action. Lessening the tendency to rely more heavily on current events and circumstances requires a thorough evaluation of all possible outcomes (both positive and negative) that may confront the company in the future. Often, it is also helpful to intentionally seek out differing opinions from various sources to more clearly understand the full spectrum of possible outcomes.
- Conservatism Bias – In contrast to Recency Bias, Conservatism Bias is the tendency to maintain long-standing views and opinions about projected financial performance in the face of new (and potentially contradictory) information about the state of the company, competitive conditions, or the economic environment as a whole. Often, Conservatism Bias comes in the form of placing too high of a probability on reversion to long-term performance levels and discounting what truly is the “new normal” facing the company in the future. Similar to confronting Recency Bias, minimizing Conservatism Bias requires critical evaluation of the likelihood of potential future outcomes and a realistic assessment of the current conditions in the marketplace, how they have changed over time, and their ultimate impact on the company’s economic moat.
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