How good are you at predicting the market?
Picture this: The Wall Street Journal hosts an exclusive contest for its valued subscribers. Each participant is presented with a collection of 100 captivating photos featuring an array of men and women. The challenge? Select the six individuals deemed most attractive. The subscriber whose choices align with the majority will be crowned the winner, walking away with a staggering $1 million prize.
What strategy would you employ to win the contest?
At first glance, it may appear obvious to select the six individuals you find most visually appealing. However, the competition does not honor the individual who chooses based on attractiveness alone. Instead, it rewards the person who selects the most widely favored photographs.
The renowned economist John Maynard Keynes initially introduced this thought experiment in his seminal work of 1936: The General Theory of Employment, Interest and Money.
In order to emerge victorious in this competition, it is crucial to determine the individual who has the most appeal from the average subscriber. However, the difficulty lies in the fact that numerous other participants are also aware of this objective. In response to this predicament, Keynes aptly states:
“We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”
Keynes uses the concept of a newspaper contest, commonly referred to in the field of economics as “the beauty contest,” to illustrate the mindset needed for predicting market fluctuations. In doing so, he highlights the importance of thoughtful consideration and strategic thinking in anticipating market movements.
Achieving success in the game of market prediction goes beyond mere calculations of expected returns. It necessitates delving into the psychological realm of comprehending how the crowd perceives its own perception.
The Majority of Investors Lack a Competitive Advantage (And That Includes You)
Far too frequently, I come across variations of the following sentiment:
“I have concerns regarding __________ and anticipate a potential market downturn. To prepare myself, I want to lower my stock exposure or make other adjustments to my portfolio.”
The range of concerns is vast and ever-changing. From politics, the value of the dollar, and national debt, to monetary policy, the entitlement system, and war. Then there are valuations, market highs, interest rates, the Eurozone, and China. The list goes on. After reading popular print or internet publications, listening to “pundits,” or engaging in social chatter, most people fill in the blank with something specific.
This line of thinking not only disregards the perception of the crowd but also oversimplifies the multitude of variables that influence market movements.
The stock market is a complex adaptive system where linear thinking, such as A causes B, falls short. Many non-professional investors, as well as some professionals, tend to rely on linear reasoning when contemplating the stock market. This is because the human brain has a natural inclination to seek precise cause-and-effect relationships. Nonetheless, understanding the intricacies of this market system requires a more nuanced perspective.
Wall Street and the financial media exploit this cognitive bias by consistently providing concise narratives to explain the past. However, we must not overlook the advantage of hindsight they possess. Consequently, we fall into the illusion that market movements can be easily explained, leading us to believe they can also be predicted. This belief in prediction is what drives subscription sales and attracts viewers.
Reading the newspaper and staying up-to-date with market news won’t suffice in predicting the next move of the market. What you truly need is an advantage or a distinctive viewpoint that sets you apart from the crowd. Here lies the challenge: you lack access to exclusive information that would provide you with that crucial advantage or perspective.
Dedicated investors and investment firms tirelessly analyze the market to uncover potential mispricings and capitalize on profitable opportunities. With extensive research budgets amounting to billions of dollars, they employ highly qualified experts armed with Bloomberg terminals. These professionals, equipped with vast amounts of data, work diligently on their trading floors.
Certain well-funded organizations take additional measures to acquire unconventional data sources, such as satellite imagery of agricultural land and forests. Some adopt a more imaginative (or even radical) approach by creating dedicated mobile gaming applications for truck drivers. These apps serve as a means to extract valuable insights about shipments and inventory that would otherwise remain inaccessible to the general public.
In the past, relying on newspapers and the internet was sufficient. However, it’s important to note that times have changed. While having a laptop and internet connection could have given you a competitive advantage in the investment world during the 1970s and 1980s, that’s not the case anymore. Today, having access to information is no longer enough to stay ahead.
Your opinion is already factored into the market prices.
When you attempt to predict market trends, you are pitted against the most brilliant and diligent minds in the world. Armed with an abundance of information, much of which is beyond the realm of imagination for most, they can calculate the projected returns on individual stocks or entire stock markets through the utilization of the following equation.
Expected Return = Book Value + (Future Cash Flows / Discount Rate)
This may seem like a straightforward equation, but in reality it is a remarkably intricate concept. It encompasses not only the assessment of risk and uncertainty associated with future cash flows, but also the market’s psychology and perception of the overall environment. Consequently, successfully capitalizing on market predictions necessitates a profound understanding of both the rational calculations and irrational behaviors that influence returns.
Your opinion that ________ will inevitably cause our next economic downturn holds little weight when considering the vast amount of information available. It is likely already factored into current market prices. While there may be occasional instances where you are correct by chance, I would wager that if you were to document every date and reason you expressed pessimism about future market returns, your track record would be far worse than you realize.
This doesn’t reflect negatively on your abilities, intelligence, or talent as an individual. It simply acknowledges the reality of the market. Even the most brilliant professionals find it challenging to be correct 50% of the time, and their profitability from being right is even lower.
Avoid predicting the market; instead, focus on planning.
It is prudent to anticipate that market downturns will persist with comparable frequency in the future. Consequently, we prepare for such downturns, and it is wiser to anticipate their regular occurrence rather than attempting to outmaneuver the market and predict the timing of stock market declines.
Keep in mind that you lack a definitive advantage in accurately predicting market movements. However, you possess numerous inherent benefits compared to other market participants when you streamline your investment approach and minimize reliance on predictions.
Becoming a long-term investor is deceptively challenging as the long-term often feels like an eternity in the present moment. Moreover, many individuals significantly underestimate their actual investing time frame, further fueling the inclination to shy away from temporary losses.
To effectively combat this, it is beset to disregard the constant noise from Wall Street media and refrain from closely monitoring the market. If you find yourself feeling anxious about market fluctuations, it would be more beneficial to review the fundamental assumptions of your financial plan rather than making hasty changes to your portfolio. This approach allows you to allocate less time to speculation and instead focus on areas that you have greater control over.