How many times have you seen a standard disclaimer about past performance not being a good guide to the future? And internally nodded wisely, thinking that of course it’s not, the disclaimer is there to warn less sophisticated people than you.
How many times have you calibrated a model based on past performance? And recent past performance, at that. Are you using inflation estimates of 10% or even 15%? We were, back in the 80s, but that would look pretty stupid now. We looked at what was happening at the time, and assumed that current trends would continue.
There’s a really interesting piece by Ian Kelly over at Pieria that discusses this type of behaviour in the context of macro-economic modelling. But the principles are the same in all modelling, I reckon.
Kelly is actually discussing an article by Lawrence Summers and Lant Pritchett, which explains why China and India are unlikely to continue on their current growth trajectories for the next twenty years. They say “The single most robust empirical finding about economic growth is low persistence of growth rates. Extrapolation of current growth rates into the future is at odds with all empirical evidence about the strength of regression to the mean in growth rates.”
When it comes to forecasting future growth, they suggest, past growth performance is of very little value.
Pritchett and Summers demonstrate this by examining the growth history of different developing economies and comparing the growth rate they enjoyed as they developed, as it were, with the growth rate that followed this period. They found that, in most instances, there was more variation in growth rates over time within the same country than there was between different countries.
Modelling is really difficult. Modelling the future is really, really difficult. It’s not going to be the same as the past, or if it is, it’s going to be the same in ways we don’t expect.