Thursday, February 10, 2011

Understanding Market Predictions

For some reason even people who know better can’t keep themselves from listening to “experts” who make predictions about stock markets, bond markets, interest rates, and other aspects of the economy. Unfortunately, these predictions are about as valuable as confident predictions of the numbers for the next lottery draw.

Many naive investors who lose money when stock markets drop are unhappy with their investment advisors. They think their advisors should have seen the losses coming and should have done something to avoid them. The truth is that no investment advisor can reliably see these things coming. These investors are doomed to be unhappy every time there is a significant drop in equity prices.

Expecting market predictors to make accurate forecasts is about as logical as expecting someone to be able to predict the next spin of a roulette wheel. How much money will you plunk down on number 23 if a well-spoken “seer” says that 23 will come up next? This makes about as much sense as relying on specific stock market predictions.

All is not lost, though. Even if we can’t make specific predictions reliably, we can say some useful things. Getting back to the roulette analogy, we can say that there are 38 numbers (1 to 36 plus 0 and 00) and that each has a 1 in 38 chance of coming up next. With this information we can answer such questions as how likely am I to double my $100 if I bet $10 on red until my money is either doubled or gone? (Answer: 26%)

The person who can properly analyze roulette can answer a number of questions, but can never predict what number will come up on the next spin. Similarly, investing experts can say useful things about the range of possible outcomes of investing in different types of assets, but cannot say what will happen to stocks over the next year.

The good news is that if an expert properly takes into account good and bad investing outcomes and their probabilities, it is possible to devise investing strategies that match an investor’s needs. But this is a very different process from making specific market predictions. Avoiding losses in investments that have risk is impossible; the real game is to control exposure to risk and to achieve life’s financial goals.


  1. I'm pretty much ammune to the stock market goes up, it goes down, I know I'm in it for the long haul.

    My wife and I just signed a purchase agreement to build a new house and I have to admit that I am nervous about the real estate market and interest rates. The thought of a real estate crash and/or sky rocketing interest rates probably caused us to delay our purchase by 6 months.

    I know that fundamentally we will be fine, we have a +20% downpayment and aren't stretching ourselves too thin with monthly payments. Still, maybe it's harder to ignore the expert opinions when you are just about to make a major financial decision.

  2. Of course I meant "immune" to the stock market noise :)

  3. @Echo: Whenever I hear gurus making predictions about assets I own I find it affects me. Fortunately, I've been at this long enough that this doesn't lead to any actions on my part any more. I find it best to try to avoid even hearing any intelligent-sounding predictions.

  4. While in essence your post is correct, I think it leaves the wrong impression that one cannot make an educated guess. The truth is somewhere in between. There is no magic formula for safe and profitable investing - if there was there wouldn't be so many gurus. At the same time, one should not pick stocks with darts, since this is not a good way. Follow some rules of thumb - many of which you presented - and by following those one can make an educated guess. And as Echo says - being in for the long haul and trust the economical indicators and not the soothsayers.

  5. @Andi: To the extent that one can make an educated guess, this information is already factored into prices. For the majority of investors who try to beat the market (and I include myself for the way I used to invest), their efforts are essentially random with a negative expectation relative to the market. Further, I don't believe that most investors can derive anything useful from economic indicators.

    None of this precludes a small minority of investors from beating the market with skill. But I think this minority is very small.