Reference class forecasting - AbsoluteAstronomy.com

Reference class forecasting
Forecasting
Forecasting is the process of making statements about events whose actual outcomes have not yet been observed. A commonplace example might be estimation for some variable of interest at some specified future date. Prediction is a similar, but more general term...

is the method of predicting the future, through looking at similar past situations and their outcomes.

Reference class forcasting predicts the outcome of a planned action based on actual outcomes in a reference class of similar actions to that being forecast. The theories behind reference class forecasting were developed by Daniel Kahneman

Daniel Kahneman

Daniel Kahneman is an Israeli-American psychologist and Nobel laureate. He is notable for his work on the psychology of judgment and decision-making, behavioral economics and hedonic psychology....

and Amos Tversky

Amos Tversky

Amos Nathan Tversky, was a cognitive and mathematical psychologist, a pioneer of cognitive science, a longtime collaborator of Daniel Kahneman, and a key figure in the discovery of systematic human cognitive bias and handling of risk. Much of his early work concerned the foundations of measurement...

. The theoretical work helped Kahneman win the Nobel Prize in Economics. The methodology and data needed for employing reference class forecasting in practice in policy, planning, and management were developed by Oxford professor Bent Flyvbjerg

Bent Flyvbjerg

Bent Flyvbjerg is the first Chair and BT Professor of Major Programme Management at Oxford University's Saïd Business School and is Founding Director of the University's BT Centre for Major Programme Management. He was previously Professor of Planning at Aalborg University, Denmark and Chair of...

and the COWI consulting group in a joint effort. Today, reference class forecasting has found widespread use in practice in both public and private sector policy and management.

Kahneman and Tversky (1979a, b) found that human judgment is generally optimistic due to overconfidence and insufficient consideration of distributional information about outcomes. Therefore, people tend to underestimate the costs, completion times, and risks of planned actions, whereas they tend to overestimate the benefits of those same actions. Such error is caused by actors taking an "inside view," where focus is on the constituents of the specific planned action instead of on the actual outcomes of similar ventures that have already been completed.

Kahneman and Tversky concluded that disregard of distributional information, that is, risk, is perhaps the major source of error in forecasting. On that basis they recommended that forecasters "should therefore make every effort to frame the forecasting problem so as to facilitate utilizing all the distributional information that is available" (Kahneman and Tversky 1979b, p. 316).

Using distributional information from previous ventures similar to the one being forecast is called taking an "outside view". Reference class forecasting is a method for taking an outside view on planned actions.

Reference class forecasting for a specific project involves the following three steps:

Identify a reference class of past, similar projects.
Establish a probability distribution
Probability distribution
In probability theory, a probability mass, probability density, or probability distribution is a function that describes the probability of a random variable taking certain values....

for the selected reference class for the parameter
Parameter
Parameter from Ancient Greek παρά also “para” meaning “beside, subsidiary” and μέτρον also “metron” meaning “measure”, can be interpreted in mathematics, logic, linguistics, environmental science and other disciplines....

that is being forecast.
Compare the specific project with the reference class distribution, in order to establish the most likely outcome for the specific project.

Whereas Kahneman and Tversky developed the theories of reference class forecasting, Flyvbjerg and COWI (2004) developed the method for its practical use in policy and planning. The first instance of reference class forecasting in practice is described in Flyvbjerg (2006). This was a forecast carried out in 2004 by Ove Arup

Ove Arup

Sir Ove Nyquist Arup, CBE, MICE, MIStructE known as Ove Arup, was a leading Anglo-Danish engineer and generally considered to be one of the foremost architectural structural engineers of his time...

of the projected capital costs for the Edinburgh Trams Line 2 proposal. The promoter's forecast estimated a cost of £320 million including allowance for contingency. Taking all available distributional information into account, based on a reference class of comparable rail projects, the reference class forecast estimated an 80th percentile value of £400 million. A report issued in August 2011 estimated that the final cost of the yet unfinished project would be over £1 billion, for a shorter tram line than the proposed Line 2.

Since the Edinburgh forecast, reference class forecasting has been applied to numerous other projects in the UK, including the £15 (US$29) billion Crossrail project in London. After 2004, The Netherlands, Denmark, and Switzerland have also implemented various types of reference class forecasting. In 2005, the American Planning Association

American Planning Association

The American Planning Association is a professional organization representing the field of city and regional planning in the United States. The APA was formed in 1978 when two separate professional planning organizations, the American Institute of Planners and the American Society of Planning...

(APA) endorsed reference class forecasting and recommended that planners should never rely solely on conventional forecasting techniques:

"APA encourages planners to use reference class forecasting in addition to traditional methods as a way to improve accuracy. The reference class forecasting method is beneficial for non-routine projects ... Planners should never rely solely on civil engineering technology as a way to generate project forecasts" (the American Planning Association 2005).

Before this, in 2001 (updated in 2006), AACE International

AACE International

AACE International was founded in 1956 by 59 cost estimators and cost engineers during the organizational meeting of the American Association of Cost Engineering at the University of New Hampshire in Durham, New Hampshire. AACE International Headquarters is located in Morgantown, West Virginia, USA...

(the Association for the Advancement of Cost Engineering) included Estimate Validation as a distinct step in the recommended practice of Cost Estimating (Estimate Validation is equivalent to Reference class forecasting in that it calls for separate empirical-based evaluations to benchmark the base estimate):

"The estimate should be benchmarked or validated against or compared to historical experience and/or past estimates of the enterprise and of competitive enterprises to check its appropriateness, competitiveness, and to identify improvement opportunities...Validation examines the estimate from a different perspective and using different metrics than are used in estimate preparation." (AACE International 2006)

In the process industries (e.g., oil and gas, chemicals, mining, energy, etc. which tend to dominate AACE's membership), benchmarking (i.e., "outside view") of project cost estimates against the historical costs of completed projects of similar types, including probabilistic information, has a long history (Merrow 1990).

See also