Decision Making

&
Forecasting

Dr. Sharad Varde

 Forecasting Methods
Basic Concepts of Forecasting
Qualitative Methods of Forecasting
Quantitative Techniques of Forecasting
 - Causal Models
 - Time Series Models
Selection of Right Forecasting Method

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 Quantitative Techniques:
Time Series Models
I. Trend Projection Models
II. Smoothing Techniques
III. Decomposition Model
IV. Box-Jenkins Model.

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Quantitative Techniques of
Forecasting
Time Series Models:
Smoothing Techniques
 When to Use
Smoothing Techniques
When the graph of forecast variable Y
against time T does not clearly exhibit a
single known pattern
When, in fact, it hints at many patterns
When the plotted points fluctuate too
much around a known curve (be it a
polynomial, exponential or modified
exponential).
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 Illustration
Y

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 Role of Smoothing
 As the name connotes, ‘smoothing’ irons
out sharp edges and softens the data
 It tries to suppress or eliminate random &
erratic fluctuations in the historical data
 Smoothing thus highlights the hidden
underlying basic pattern
 Useful to obtain quick short term forecasts
of several individual component factors
comprising an ‘aggregate macro variable’.
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 Illustration
Y

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 Illustration
Y

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 Basic Steps in Smoothing

A. To Compute smoothed values based on

historical data on the forecast variable

B. To use the smoothed value computed in

‘A’ as a forecast for immediate future

period of time.
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Standard Smoothing Techniques

1. Naïve Method
2. Simple Moving Average
3. Simple Exponential Smoothing
4. Double Moving Average
5. Double Exponential Smoothing

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 1. Naïve Method
Principle: Immediate past is best predictor
of immediate future (Horizontal Pattern)
Example: Leaving home early on Tuesday
because you faced extra traffic on Monday
Naïve Model: Forecast of Y at time t+1 is
the actual observed value of Y at time t.
Statistical Model: Ŷt+1 = Yt
Simple, but, has obvious drawbacks.
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 2. Simple Moving Averages
A step forward from the Naïve Method
Not the last observation, but the average
of last few observations is the forecast
Ŷt+1 = (Yt + Yt-1) / 2 is called the moving
average of period 2
Ŷt+1 = (Yt + Yt-1 + Yt-2 ) / 3 is called the
moving average of period 3
Judgment: How far to go in the past.
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 2. Simple Moving Averages
How to decide: ‘How far to go in the past’?
Indicator: Mean Square Error (MSE)
Method: Compute moving averages of
different periods, compare with actual data
& select that period which shows min MSE
Advantage: Computation: Little & Manual
Limitation: Good only for horizontal pattern

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2. Simple Moving Averages
Year Yt Ŷt N=3
01 100
02 116
03 102
04 114
05 80
06 95
07 91
08 87
09 86
10 85

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2. Simple Moving Averages
Year Yt Ŷt N=3
01 100
02 116
03 102
04 114 106
05 80 111
06 95 99
07 91 96
08 87 89
09 86 91
10 85 88

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2. Simple Moving Averages
Year Yt Ŷt N=3 Ŷt N=5 Ŷt N=7
01 100
02 116
03 102
04 114 106
05 80 111
06 95 99
07 91 96
08 87 89
09 86 91
10 85 88

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 2. Simple Moving Averages
Year Yt Ŷt N=3 Ŷt N=5 Ŷt N=7 E N=3 E N=5 E N=7
01 100
02 116
03 102
04 114 106
05 80 111
06 95 99 102
07 91 96 101
08 87 89 96 100
09 86 91 93 98
10 85 88 88 94

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 2. Simple Moving Averages
Year Yt Ŷt N=3 Ŷt N=5 Ŷt N=7 E N=3 E N=5 E N=7
01 100
02 116
03 102
04 114 106 8
05 80 111 -31
06 95 99 102 -4 -7
07 91 96 101 -5 -10
08 87 89 96 100 -2 -9 -13
09 86 91 93 98 -5 -7 -12
10 85 88 88 94 -3 -3 -9
TSE
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MSE
 2. Simple Moving Averages
Year Yt Ŷt N=3 Ŷt N=5 Ŷt N=7 E N=3 E N=5 E N=7
01 100
02 116
03 102
04 114 106 8
05 80 111 -31
06 95 99 102 -4 -7
07 91 96 101 -5 -10
08 87 89 96 100 -2 -9 -13
09 86 91 93 98 -5 -7 -12
10 85 88 88 94 -3 -3 -9
TSE 1104 300 394
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MSE 158 60 132
 2. Simple Moving Averages
Total Square Error:
1104 (for N=3), 300(for N=5), 394(for N=7)
Mean Square Error:
158(for N=3), 60(for N=5), 132(for N=7)
Select moving av. of period 5 for forecast
Y10 + Y09 + Y08 + Y07 + Y06
Forecast Ŷ11 = --------------------------------- = 88.8
5

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3. Simple Exponential Smoothing
 Basis: Most recent data are more informative,
more valuable & so more useful than older data
 So, recent data deserve more weightage
 Exponential smoothing = weighted moving avg.
 Select a smoothing constant α (0 < α < 1)
 Ŷt+1 = αYt + (1- α) Ŷt Assumption: Ŷ1 = Y1
 Ŷt+1 = αYt + α(1- α)Yt-1 + α(1- α)2Yt-2 + . . . .
. . . . . . . . . . . . . . . . . . . + α(1- α)t-1Y1
 Note α, α(1- α), α(1- α)2, ... in decreasing order.
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3. Simple Exponential Smoothing
Year Yt Ŷt α =.3 Ŷt α =.5 Ŷt α =.9 E α =.3 E α =.5 E α =.9
01 300
02 235
03 285
04 297
05 420
06 275
07 255
08 240
09 320
10 380
11 340
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MSE
3. Simple Exponential Smoothing
Year Yt Ŷt α =.3 Ŷt α =.5 Ŷt α =.9 E α =.3 E α =.5 E α =.9
01 300
02 235 300 300 300
03 285 281 268 242
04 297 282 276 281
05 420 286 287 295
06 275 326 353 408
07 255 311 314 288
08 240 294 285 258
09 320 278 262 242
10 380 291 291 312
11 340 317 336 373
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MSE
3. Simple Exponential Smoothing
Year Yt Ŷt α =.3 Ŷt α =.5 Ŷt α =.9 E α =.3 E α =.5 E α =.9
01 300
02 235 300 300 300 -65 -65 -65
03 285 281 268 242 4 17 43
04 297 282 276 281 15 21 16
05 420 286 287 295 134 133 125
06 275 326 353 408 -51 -78 133
07 255 311 314 288 -56 -59 -33
08 240 294 285 258 -54 -45 -18
09 320 278 262 242 42 58 78
10 380 291 291 312 89 89 68
11 340 317 336 373 23 4 -33
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MSE 4127 4553 5285
3. Simple Exponential Smoothing
Mean Square Error: 4127(for α = 0.3)

Fix smoothing constant α = 0.3 to forecast

Forecast Ŷ12 = αY11 + (1- α) Ŷ11

= 0.3 (340) + 0.7 (317) = 324

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 4. Double Moving Averages
 Useful to handle upward/downward trend pattern
 Moving averages of simple moving averages
 Let N be the period of moving average
 Let St be Simple moving average for time t:
St = (Yt + Yt-1 + Yt-2 + . . . + Yt-N+1 ) / N
 Let Dt be Double moving average for time t:
Dt = (St + St-1 + St-2 + . . . + St-N+1 ) / N
 Forecast Ŷt+1 = 2St – Dt + [2/(N – 1)] [St – Dt].

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 4. Double Moving Averages

 Numerical Example: Forecast Steel Production

 Moving average of period 3 selected by MSE

 Forecast Ŷt+1 = a + b

 Where a = 2St – Dt and b = [2/(N – 1)] [St – Dt]

 Data: Nine years of Steel Production in tons

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4. Double Moving Averages
t Yt
1 450
2 500
3 518
4 455
5 502
6 545
7 557
8 586
9 612
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4. Double Moving Averages
t Yt St Dt
1 450
2 500
3 518
4 455
5 502
6 545
7 557
8 586
9 612
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4. Double Moving Averages
t Yt St Dt a b Ŷt+1
1 450
2 500
3 518 489.33
4 455 491.00
5 502 491.67 490.67
6 545 500.67 494.45
7 557 534.67 509.00
8 586 562.67 532.67
9 612 585.00 560.78
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4. Double Moving Averages
t Yt St Dt a b Ŷt+1
1 450
2 500
3 518 489.33
4 455 491.00
5 502 491.67 490.67 492.67 1.00
6 545 500.67 494.45 506.89 6.22 493.67
7 557 534.67 509.00 560.34 25.67 513.11
8 586 562.67 532.67 592.67 30.00 586.01
9 612 585.00 560.78 609.22 24.22 622.67
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4. Double Moving Averages

Forecast

Ŷ10 = 609.22 + 24.22 = 633.44 MT

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 5. Double Exponential Smoothing

 Trend pattern and gradually reducing weights

 Let St be Simple exponential average for time t:
St = αYt + (1- α)St-1
 Let Dt be Double exponential average for time t:
Dt = αSt + (1- α)Dt-1
 Forecast Ŷt+1 = 2St – Dt + [α /(1 – α)] [St – Dt]
 The best value of α is determined using the
Mean Square Error method.

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 5. Double Exponential Smoothing

 Numerical Example: Forecast Annual Rainfall

 Smoothing constant α = 0.3 selected by MSE

 Forecast Ŷt+1 = a + b

 Where a = 2St – Dt and b = [α /(1 – α)] [St – Dt]

 Ten years data on Annual Rainfall in cms.

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t Yt St Dt a b Ŷt+1
1 320 320 320

2 329 322.7 319.19 326.21 1.5093

3 325 323.39 320.45 326.33 1.2642 327.72

4 304 317.57 319.59 315.55 -0.8686 327.59

5 328 320.70 319.92 321.48 0.3354 314.68

6 325 321.99 320.54 323.44 0.6235 321.82

7 347 329.49 323.23 335.75 2.6918 324.06

8 349 335.34 326.86 343.82 3.6464 338.44

9 366 344.54 332.16 356.92 5.3234 347.47

10 385 356.68 339.52 373.84 7.3788 362.24

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5. Double Exponential Smoothing

Forecast

Ŷ11 = 373.84 + 7.3788 = 381.22 cms

…

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