August 8, 2005

No Prediction

"One of the greatest popular myths about investing in stocks is that in order to be successful, you must be able to predict the stock market's movements. Why do people assume this? For some, it is because they do not understand that stocks give a positive and substantial return over time - they falsely assume that stocks bounce around in the same range forever, and they therefore conclude they must predict movements in order to be able to sell at the top of the range and buy at the bottom of the range. For others, the desire to predict is borne out of human nature, which puts a premium on certainty. We love to know what will happen in advance. Hence, it is usually assumed by the beginning investor that to be successful, one must first become an expert at forecasting future market trends. Experienced investors know, in fact, that nothing could be further from the truth. Some icons of Wall Street love to advance the cause of market predicting, because they are paid to predict these movements. Others simply humor their clients who are looking for market projections because they know that it is easier to give them a projection than to try to correct the clients' thinking. For instance, nearly every retail brokerage firm has a chief economist or market strategist whose main responsibility is to predict the climate for stocks. A large number of books, advisory services, and such that are sold focus themselves almost exclusively on prediction of how the stock market in general will perform in the future. But in truth, the best way to make money in the stock market is to avoid approaches that rely on market predictions. This will most likely seem an odd or even a absurd statement to some, perhaps most. Yet, any serious review of the results of market gurus over a long period of time reveals a track record that is no better (usually worse than) a simple buy-and-hold strategy. Don't misunderstand me: There is no doubt that if a person could accurately predict the short-term fluctuations of the stock market, that person could far exceed the return of someone who simply bought a basket of stocks and sat on them. However, the one fatal problem with this is that there has never been a single person who has figured out how to do it. Nearly all market advisors claim to be able to call the market's every turn, but in fact every credible study ever done on the subject has proven that these claims are invariably false. By far, most market prognosticators significantly underperform the market, despite their universal claims to the contrary. Given the large number of market gurus that now exist, the laws of statistics dictate that some of them must beat the market, out of pure luck if nothing else. However, they lack the ability to repeat this performance from one time period to another, and the group of market beaters will usually be a different group every time period that is sampled. If you could predict which guru would be right for the next year, you would be in good shape. But, of course, it's just as hard to predict which guru (or which dart board) will be right for the coming year as it is to accurately predict market conditions. Finally, even if we are generous and assume that there is some market forecaster out there who has the holy grail of market prediction, our chances of being able to sort him out from those who simply got lucky are pretty slim."

Investopedia