Coronavirus, Ray Dalio and forecasting in an age of uncertainty

It is never easy to admit that you are wrong; especially when you have previously earned fame (and billions of dollars) by calling the future right.

However, Ray Dalio, founder of the world’s largest hedge fund, Bridgewater Associates, has done just that. After it emerged that his flagship fund was down about 20 per cent since the start of the year, Dalio admitted that he had been caught flat-footed by the recent coronavirus-driven market swings — in sharp contrast to the 2008 financial crisis, when he and his team predicted events with such prescience that they profited handsomely.

“We’re disappointed because we should have made money rather than lost money in this move, the way we did in 2008,” he told the FT. It seems that the systems that Bridgewater developed to analyse the flows of finance and economic activities — which have traditionally driven its bets on the direction of stocks, bonds and other securities — did not offer any guidance when looking at a rare event such as the current pandemic.

“We did not know how to navigate the virus and chose not to because we didn’t think we had an edge in trading it,” Dalio went on to explain. “So, we stayed in our positions and, in retrospect, we should have cut all risk.”

Now, many readers may feel baffled by this, given that the whole point of investing with a hedge fund is that they are supposed to beat the markets at times of stress (Dalio himself has published extensive advice on how to handle turbulence).

However, I think that scorn is the wrong response here. Never mind the fact that Bridgewater is far from the only fund to suffer big losses and that Dalio has admitted to his mistakes (which is a more honest approach than most of his rivals).

What is interesting to ponder is what this episode reveals about the nature of forecasting — and our modern attitudes towards time.

As anthropologists often point out, the way we think about time is a defining feature of the post-enlightenment world. During much of human history, the future was viewed as a vague and terrifyingly unknowable blur marked by constant bargaining with deities (to ward off disaster) or cyclical seasonal rhythms (of the sort that underscore Buddhist cognitive maps).

In modern, post-enlightenment western cultures, however, a linear vision of time emerged that presumes the past can be extrapolated into the future, with a sense of progression, not just cyclicality.

In the 20th century, this gave birth to the risk management and finance professions, as Peter Bernstein wrote two decades ago in his brilliant book Against the Gods: the Remarkable Story of Risk.

By the turn of the century, innovations such as computing and the internet were turbocharging the forecasting business to an extraordinary degree, as Margaret Heffernan notes in her excellent (and very timely) new book Uncharted. “Human discomfort with uncertainty . . . has fuelled an industry that enriches itself by terrorising us with uncertainty and taunting us with certainty,” she writes.

However, as Heffernan stresses, while the forecasting business has made its “experts” very rich, it is also based on a fallacy: the idea that the future can be neatly extrapolated from the past. Moreover, the apparent success of some pundits in predicting events (such as the 2008 crash) makes them so overconfident that they get locked into particularly rigid models. “The harder economists try to identify sure-fire methods of predicting markets, the more such insight eludes them,” she writes.

Is there a solution? Heffernan’s answer is to embrace uncertainty, build resilience, use “narrative” (or qualitative) analyses instead of rigid models and to respect the wisdom of diverse views to avoid tunnel vision. Strikingly, in the wake of the 2008 crisis, some economists agree.

Indeed, Mervyn King, former governor of the Bank of England, has just joined forces with his fellow economist and former FT columnist John Kay to pen a thoughtful tome, Radical Uncertainty, which echoes Heffernan’s points.

“Over 40 years the authors have watched the bright optimism of a new, rigorous approach to economics — which they shared — dissolve into the failures of prediction,” they write, arguing that the modern community of economists and policymakers needs to accept radical uncertainty and rethink its models.

This is sensible. But to my mind there is another way to frame this debate: to treat models (whether they emerge from computer science or economics) like a compass in a dark wood at night. Navigation tools can give you a sense of direction and orientation; it would be ridiculous to toss them out entirely.

However, if you rely exclusively on them, accidents occur. If you walk through a wood just looking down at the dial of a compass, you will bang into a tree or worse. The trick, then, is to use navigation aids but also to maintain your peripheral vision.

I would argue that using the insights of cultural anthropology is one way to do this, since it provides a social context for looking at our favoured tools (and thus a way to see their shortcomings). Others might argue that peripheral vision simply stems from common sense.

Either way, now more than ever, we need this broader perspective — and humility — when we try to assess what might happen next, not just with the markets but with the coronavirus outbreak too.

Follow Gillian on Twitter @gilliantett or email her at gillian.tett@ft.com

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