Many financial advisers like to give the impression that they can predict the future — that they know what will happen to the economy, or whether the markets will rise or fall. Others may admit they don’t know, and yet claim to be able to identify experts who do have that ability. But how predictable are the financial markets in reality?
One of the first things new clients notice when they first start working with rockwealth is that we don’t like making predictions — and we certainly don’t base our investment strategy on them.
Why not? Well, predicting the future is very hard, whether it’s anticipating the outcome of elections or referendums, military conflicts, or indeed pretty much everything else. Economic predictions in particular are notoriously hit and miss.
More importantly, correctly predicting something is one thing, but profiting from it as an investor is another matter entirely. Time and again the financial markets do the very opposite of what the so-called experts are predicting.
The truth is that, at least in the short term, market movements are totally unpredictable, and that’s one of the fundamental principles of our evidence-based investment philosophy.
A FLOATING LEAF
Imagine you’re watching a leaf floating on a pond. The leaf drifts in different directions, buffeted by the breeze or by tiny ripples. It’s impossible to predict exactly where it will go next. A French mathematician named Louis Bachelier explained in a thesis written in 1900 how the prices of stocks and bonds move in a similarly unpredictable manner.
In fact, Bachelier used a more colourful analogy. Watching the markets, he wrote, is like watching a drunkard walk down the street. This in turn led to a phrase that’s still widely used in the financial world — the random walk.
In essence, the random walk theory posits that future price changes are not dependent on past price changes. In other words, knowing how a stock performed in the past will not help you predict how it will perform in the future. All known information about a particular security is already reflected in the price.
What causes the price to move, then, is new information, and the adjustment happens within seconds.
In a bygone era, people used to profit by trading on inside information. But that is now illegal, so everyone in theory has access to the same information at the same time.
There are hundreds of millions of investors around the world, and securities are being bought and sold thousands of times every second. That’s why it’s highly unlikely that any one investor will be better informed about a particular stock or bond than the whole of the rest of the market.
IMPLICATIONS FOR INVESTORS
So, if you believe that short-term market movements are random, as we at rockwealth do, what are the implications for investors?
Well, the most important one is that you can’t expect to beat the market. To use Louis Bachelier’s famous phrase, “the expectation of the speculator is zero.”
You might at this point be thinking, “If it’s impossible to predict stock movements, why do so many people try to do it? Why are the money sections of the weekend papers full of ideas on stocks or funds to invest in?” These are highly pertinent questions to ask!
Around the world there are hundreds of thousands of people who are paid to pick stocks and anticipate market movements. They use various methods to do it. One is technical analysis, which bases forecasts on historical price data and trading volumes. Another is fundamental analysis, which involves evaluating a company’s intrinsic value by analysing key metrics.
But does any of this add any real value for investors? There is very little evidence that it does.
A SEMINAL BOOK
So, if trying to beat the market through active stock selection and market timing is a futile endeavour, what’s the answer?
Three sensible alternative suggestions are made in a seminal book by the American academic Burton Malkiel called A Random Walk Down Wall Street.
— Diversify your investments
Because we can’t predict the markets, Malkiel says it’s important to reduce your risk by having a well-diversified portfolio, including both stocks and bonds, and perhaps property as well. “Broad diversification,” he says, “rules out extraordinary losses relative to the whole market.”
— Use index funds
Picking active funds that will outperform is very difficult, Malkiel explains. The vast majority will lag the market in the long run. The logical choice, he says, is to use index funds instead. These are funds that track the entire market and have the added benefit of benefit very much cheaper.
— Watch your behaviour
“There are four factors that create irrational market behaviour,” Malkiel writes. “(They are) overconfidence, biased judgments, herd mentality, and loss aversion.” Investors, he says, should try to block out market “noise” and simply stay invested, resisting the temptation to act on emotions like fear and greed.
INVESTING ISN’T MEANT BE EXCITING
Of course, the investment strategy that Burton Malkiel recommends is not exactly exciting. But investing isn’t supposed to be exciting.
As the Nobel Prize-winning economist Paul Samuelson once said: “investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”
And if gambling isn’t your thing, why not get excited about the benefits of a rational, evidence-based investment philosophy? Follow Malkiel’s advice, and you’ll probably be able to retire earlier, or with a rather bigger pension pot, than you otherwise would.
FIND OUT MORE
Want to find out more about rockwealth Aberdeen and how holistic, evidence-based financial planning can help you to achieve your goals? Then give us a call or send us a message. We would love to hear from you.