There is no shortage of pundits who offer predictions of what will happen to particular stocks or the stock market in general. You’ll find them on television, radio, and innumerable blogs. I’m open to the possibility that some investors can guess the long-term success of a particular business, but I simply don’t believe any short-term predictions that I hear.
Here is why: if these pundits actually get it right a significant fraction of the time, then they could make much more money investing based on their predictions instead of wasting their time as pundits. To prove this, I decided to run some Monte Carlo simulations.
Suppose that our pundit Peter predicts whether the S&P 500 will beat inflation each month, and he gets it right 80% of the time. So, 20% of the time when he picks stocks to win, he is wrong, and 20% of the time when he picks inflation to win, he is wrong. This may seem like only a mildly impressive record, but I’ll show how Peter can make himself fabulously wealthy.
Let’s say Peter decides to give up his life of wearing a bow tie on inane financial television shows and starts trading based on his insight. He starts by taking a $100,000 second mortgage on his home. (Fortunately, Peter bought well before the housing bubble began and has been conservative with his money until now.)
Each month, Peter will make his prediction and do one of two things:
1. If he thinks stocks will not beat inflation, he just keeps his money in cash for the month. In this case, we’ll assume that the interest he collects just keeps up with inflation.
2. If he likes stocks for the month, he leverages his money by a factor of 3 and buys an S&P 500 index fund. By “leverage” here, I mean that if he has $100,000, he borrows an additional two times this amount ($200,000), and invests the whole $300,000 in the index fund.
Before I can run the simulations to see what happens to Peter’s money, we need to factor in some assumptions about real-world stock performance and costs:
- The expected compound return of the S&P 500 will be 6% above inflation each year, with a 20% standard deviation.
- The cost of borrowing money is 5% above inflation.
- The cost of trading in and out of the index fund is 0.5% each time.
- Peter must pay 40% tax on his gains each year.
- Inflation is 4%. (This is only needed for the tax calculation. You have to pay tax on all gains, even the gains needed to keep pace with inflation.)
All of these costs are a huge burden for Peter to overcome with his market timing strategy. The simulations will tell us whether Peter’s 80% prediction rate can win out.
I piled all this data into my program and ran millions of possible futures for Peter’s money. After 20 years, there is a 90% chance that Peter will have between $1.6 million and a whopping $69 million! The median outcome was $10.3 million. These figures are in present day dollars taking into account inflation.
So, why would Peter bother being a pundit and give away his valuable insight? The answer is that he wouldn’t. I don’t pay attention to pundits who make short-term stock market predictions because I don’t believe they can get it right significantly more often than someone who tosses a coin.