Imagine The Wall Street Journal ran a contest for its subscribers in which each subscriber viewed 100 photos of various men and women. To participate in the contest, each subscriber must pick the six most attractive people. The subscriber that choses the photos voted for most often will win $1 million.
How would you win the contest?
At first blush, it may seem obvious to simply pick the six people you find most attractive. But the contest doesn’t reward the person who picks the most attractive people. It rewards the person that chooses the most popular photos.
This thought experiment was originally presented by famed economist John Maynard Keynes in his 1936 seminal work The General Theory of Employment, Interest and Money (only $1.00 on Amazon Kindle for one of the most important economic works ever!).
To win this contest, you must determine which person the average subscriber finds attractive. The challenge, however, is that many other competitors understand this as well. To this, Keynes says:
“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.”
Using the example of the newspaper contest, known in the field of economics as “the beauty contest,” Keynes explains the type of thinking required of anticipating market movements.
“Winning” the game of market prediction requires more than calculating an expected return; it requires the psychological task of understanding how the crowd perceives the crowd’s perception.
Most Investors Don’t Have an Edge (That Includes You)
All too often I hear some form of the following:
“I’m worried about __________ and think the market is going to crash. I want to reduce my exposure to stocks or make portfolio changes to prepare.”
That blank space is always something different. Politics, the dollar, national debt, monetary policy, entitlement system, war, valuations, market highs, interest rates, Eurozone, China, etc. Most people fill in the blank with something specific after reading popular print or internet publications, listening to “pundits,” or tuning in to social chatter.
Not only does this line of thinking entirely ignore the crowd’s perception, it oversimplifies the many variables that impact market movements.
The stock market is a complex adaptive system in which linear thinking – A causes B – isn’t sufficient. Most non-professional investors (along with many professionals) use linear reasoning when thinking about the stock market because the human brain is obsessed with precisely linking cause and effect.
Wall Street and the financial media play to this cognitive bias by constantly explaining the past with succinct narratives. We ignore that they have the benefit of hindsight. The result is the illusion that markets movements are easily explained, which then tricks us into believing they can be predicted. This belief in prediction is what sells subscriptions and attracts viewers.
However, reading the newspaper and keeping current with market news isn’t going to help you anticipate the market’s next move. You need an edge or a unique perspective versus the crowd. Here’s the problem: You don’t have special information that would give you that necessary edge or perspective.
I’ve spoken before about the collective knowledge of financial markets being a key reason behind the failure of active management. There are more people than ever competing for the very rare opportunity to identify and profit from market inefficiencies. Information gets quickly incorporated into prices as a result.
Brilliant investors and investment firms work around the clock to identify potential mispricings and extract any profits that may be available. They have billions of dollars in research budgets – all dedicated to finding profit opportunities within the market. Their trading floors are littered with PhDs and CFAs armed with Bloomberg terminals giving them access to more data than you can imagine.
Some well-funded outfits go even further to secure non-traditional data sources such as satellite imagery of farmland and forests. Others take a more creative (or extreme) approach and go so far as to develop mobile gaming apps exclusively for truck drivers to extract information about shipments and inventory that is otherwise unavailable to the public.
Meanwhile, you have the newspaper and internet. Don’t get me wrong, you could have run circles around the investment world in the 1970’s and 1980’s with a laptop and an internet connection. But you don’t have an edge today.
Prices Already Incorporate Your Opinion
When you make a prediction about the market, you are competing against the world’s brightest and hardest-working people. Using all available information, which includes data that most people don’t even dream about, they can formulate the expected return on a stock or market of stocks using the following equation:
Expected Return = Book Value + (Future Cash Flows / Discount Rate)
It’s a simple equation, but the discount rate is very complex. It incorporates the perceived risk and uncertainty of future cash flows as well as the market’s psychology and perception of the environment. Thus, profiting from market predictions requires a solid grasp of the rational calculus and irrational behavior that drives returns.
Your opinion that ________ will imminently cause of our next downturn just doesn’t mean much considering the wealth of information you’re up against. It’s also probably incorporated in current prices. Sure, you might get lucky and be correct every once and awhile – but I’d be willing to guess that if you wrote down every date and reason you expressed negativity about future market returns, your track record will be way worse than you think.
That doesn’t say anything negative about your abilities, intelligence, or talent as a person. That’s just the reality of the market. Even the brightest professionals struggle to be right 50% of the time, and they profit from being right even less.
Don’t Predict, Plan
It’s reasonable to expect market downturns to continue occurring with a similar degree of frequency in the future. That means we plan for them – and you’re better off planning on downturns regularly occurring than trying to outsmart the market and predict when stocks will take a tumble.
Remember, you don’t have an edge that would allow you to reliably predict what the market will do. But you do have several natural advantages versus other market participants when you simplify your investment process and limit the use of prediction.
Being a long-term investor is easier said than done because the long-term feels like an eternity in the moment. Most people dramatically underestimate their real investing time horizon, too, which intensifies the desire to avoid temporary losses.
The best way to combat this is to tune out the noise from Wall Street media and stop watching the market.
If you are nervous about the market, you are better off reviewing the underlying assumptions in your financial plan than making changes to your portfolio. That way you spend less time predicting and more focused on things you can control.