What False Assumptions Are You Making?
In financial models, we use historical data to make assumptions about the future. These assumptions lead to forecasts that ultimately help us calculate value. We can’t know what will happen in the future, so an informed assumption is the best we have.
Making an assumption when you don’t have all the data is common. An assumption could be an estimate based on experience or other data points closely related to the missing information. In making an assumption, one should have a sense of the degree of confidence attached to the assumption.
When using financial models that require assumptions, it is important to question the assumptions continually. One should always be asking, “is there a better way of doing this?” Questioning the assumption implies an awareness of the assumptions. Financial modelling is often a balance of art and science. The art is forecasting using assumptions. Science is the mathematical calculations using the input data and assumptions.
As a practitioner and a teacher of the subject of value, I get deeply emersed in my valuation work while being at arm’s length from my students’ valuations. The benefit of being at arm’s length and not emotionally attached is that it is easy to spot bias and flawed assumptions. It is also easy to see where someone is ignorant of their assumptions or making false assumptions.
It is not only in financial modelling that we make assumptions. Assumptions are part of everyday life. We assume that if a vehicle driver is not indicating, they are likely to go straight. We make assumptions based on traffic rules and past evidence that drivers mostly follow the rules. Caution is always required.
What if you are making assumptions that you don’t know that you are making? What if others are not following the rules? What if your assumptions are false?
The problem is we don’t know what we don’t know. I am confident that there is so much that I don’t know about the world. However, not knowing something like the capital city of Slovakia is unlikely to impact my life. It’s Bratislava, by the way.
For much of my life, I assumed that people in leadership positions are there because they demonstrated good leadership. I also assumed that people in leadership positions were honourable. I have long since disabused myself of these assumptions, and I now have an intolerance for people who wield power simply because they are in a leadership position. This assumption cost me a great deal of money. I was ignorant of my own assumptions! My assumptions were also false.
What assumptions are you making that you don’t know that you are making? What assumptions are you making that could be false?
Justin Spencer-Young Twitter: @fastforwardjsy