Monday, October 20, 2014

Stock Market Momentum

People tend to think of the stock market as something that moves up and down like an airplane. There are problems with this way of thinking that cause investors to make poor choices.

If the stock market really were like an airplane, it would have momentum that makes it difficult for the market to change direction from rising to falling or vice-versa. The truth is that prices can change on a dime because they are determined by the bid and ask prices of traders who can change their minds in an instant. There is a technical concept of momentum in stock prices, but it isn’t the same as momentum in physics; there is no physical object that must be slowed down and turned in the other direction.

The problem with a false analogy like the airplane is that it creates the illusion that if markets move in one direction a few days in a row, they are almost certain to continue that way for a while. But this isn’t true for stocks.

The recent downtrend in stock prices has many commentators saying that we are “in a correction.” But all we can say with any certainty is that we have had a correction. It may or may not continue. Saying that we are in a correction implies that falling prices will continue over the short term, which is far from certain.

The wiring of our brains makes humans very good as finding patterns. The trouble is that we sometimes see patterns that aren’t there. Stock prices over the short term are largely random. If you think you see a pattern, blame your brain.

13 comments:

  1. You are saying that the Stock Market does not follow the laws of Physics? Well that will cause me to change my investing strategies completely!!!

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    1. @Alan: It seems obvious that a physical constraint doen't apply when we state it clearly, but it's amazing how many investors are convinced that recent stock market prices changes are highly likely to persist.

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  2. True enough: By the time we were all writing about the latest "correction" in the markets last week, the TSX had reversed the trend on Friday.

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    1. Has it? Or was that just another gusty updraft? There is NO WAY to tell till it's all history....

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    2. @Robb: If Friday had been a down day as well, that would have given the world the whole weekend to predict the end of civilization.

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  3. This is so true and why it was so hard to decide when to exercise our soon-to-expire stock appreciation rights. It was a total guessing game. Should we exercise now? Will the market go up or down? If we waited too long expecting it to go up just a dollar more, we could wake up to find it's down 25% for no particular reason.

    Sure makes investing fun!

    And I totally fail to see how this was in any way supposed to encourage better work performance!

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    1. @BetCrooks: I don't base the exercise of options or SARs on my prediction of future stock movements. I use the analysis from one of my posts (but your mileage may vary):

      http://www.michaeljamesonmoney.com/2012/01/when-to-exercise-employee-incentive.html

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  4. This is a good reminder, Michael. I am reminded of an anecdote where researchers generated a random chart and had people analyze the pattern and predict future price movement. Of course random charts have the same shapes that technical analysts use for stock predictions. This makes sense if what you say about the random nature of stock movements is true.

    I did read a book once that proposed buying stocks at all-time highs since there will be no one waiting to sell to break even, putting downward pressure on the price. Perhaps there is some validity to this, which creeps into behavioural finance?

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    1. @Gene: You can see the same thing with people who play roulette. They believe things like a table is "hot". We're very good at seeing patterns in randomness.

      I wouldn't go so far as to say that stock prices are entirely random. In the short term they are largely random. I operate on the assumption that there are so many smart people looking for legitimate patterns that any simple things like buying at market highs isn't likely to work.

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  5. "The stock market is a cruel and shallow money trench, a long plastic hallway where thieves and pimps run free, and good men die like dogs. There's also a negative side." Adapted - Hunter S. Thompson

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    1. @Peter: Great quote. I think of myself as essentially as an observer of the stock market doing almost no trading at all, but having my money just sitting there in the market. Hopefully, that leaves me outside of the "cruel and shallow money trench."

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  6. On the subject of momentum, I came across this very interesting paper which uses ETFs in an attempt to capture both absolute and relative momentum. The results are impressive. It is from the Optimal Momentum website.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2042750

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    1. @Tristan: I was discussing momentum in a different sense, but thanks for the link. I've yet to see anything that seems to be able to reliably capture the momentum effect after fees.

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