Wednesday, October 12, 2011

Which Predictions are Profitable?

When I hear people discussing investing, they usually make predictions. Some people plan to act on their convictions. Unfortunately, many investors don’t understand that even if they are right they may not make money. Some predictions, if correct, can lead to profit, but not others.

For example, investor Bill believes RIM’s technology is inferior to that of its competitors and he sells RIM stock short. Even if he is right about RIM technology, he may not make money. The problem here is that this prediction about the future success of RIM’s technology in the marketplace may already be built into RIM’s stock price.

The important question is whether RIM’s troubles are bigger or smaller than the market believes. If another investor, Jane, is correct in her belief that while RIM has some technology difficulties, the market’s concerns are overblown, then she can make money by buying RIM stock. Both Jane and Bill may be right, but Jane will make money and Bill will lose money. All predictions have to be measured against the market sentiment that is already built into equity prices.

Another good example is interest rates. If you believe that short-term interest rates are going to rise, should you take a 5-year term on your mortgage? Current long-term rates already have expectations about changes in short-term rates built into them. If short-term rates rise, but by less than the market expected, long-term rates may drop making your 5-year mortgage term look like a bad idea.

For information about the future to be profitable, it has to be information that other people don’t have. Whenever you plan to commit money to a conviction you should ask yourself “what do I know that others don’t know?”

5 comments:

  1. It's not just what people know. For example, everyone knows that interest rates will rise if european governments pull their acts together and banks stabilize, while they will fall if bad decisions are made and confidence and trade fall. So the real question is what people believe and how future events will live up to their beliefs.

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  2. Anything which is tied to emotion (fear and greed) is hard to predict. Same is true for mortgage rates.

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  3. @Value Indexer: I think we're saying the same thing. Some people talk about what they know and others about what they believe. There are even some who talk about what they "feel". They all usually mean the same thing and are just using different language.

    @Sudip: I agree with you that the effect of human emotions on stock prices is difficut to predict.

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  4. You're absolutely right with this post. I know first hand that it's a bad feeling to be right AND lose money. Nothing like that feeling to drive the lesson home.

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  5. Great post! We agree for the first time in a long time! I would add that if average investors spend 10 minutes a year on forecasts, they have wasted 9 minutes that they can never get back.

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