The Big Lie Exposed: The Future is Not Predictable
I will prove to you that everything you thought about Wall Street is wrong. Choose any famous money manager or Wall Street guru or any billionaire, and I will show you that none has ever done better than chance over time in predicting market movement. That includes David Swensen, Warren Buffet or any senior analyst at any major brokerage house. Nobody can predict the future, no matter how wealthy, smart or lucky.
Testifying before the Senate in 1967, Nobel Prize-winning economist Paul Samuelson declared: "A typical mutual fund is providing nothing for the mutual fund owner that they could not get by throwing a dart at a dartboard." He was rekindling an idea initiated 40 years earlier by Edgar Lawrence Smith, who presented in 1926 the first credible attempt to estimate the long-term return on stocks through empirical analysis. In his book Common Stocks as Long Term Investments, Smith looked at stock investments assuming no market timing or stock selection ability whatsoever; instead he used a hypothetical investor who simply held onto stocks, and found that such an investor outperformed professional bond investors. This result, to say the least, was not highly regarded. Three years after publication, in 1929, the market collapsed and Mr. Smith fell from favor. As we will see, however, people missed the point, and in fact Edgar Smith was right. What they failed to grasp was the need to hold on to stocks long-term, even in times of significant loss in the market.
Building further on Smith's idea, and Samuelson's elaboration, Burton Malkiel published in 1973 his now-famous attack on the financial establishment in a book entitled, A Random Walk Down Wall Street. This was no ordinary academic think piece. With this book, Malkiel launched a direct and aggressive challenge to the authority of Wall Street, and his work was and is still today reviled by brokers and others with a vested interest in the status quo. In his publication, Malkiel postulated that a blindfolded monkey throwing darts at a newspaper's stock tables could outperform any stock picker over time. I am that blindfolded monkey. That is OK, I have been called worse. But I am living proof that the random walk works. Over the past five years my investments have yielded an average annual rate of return of 4.3%, and that includes all of 2008. In times of plenty such a return seems paltry, even embarrassing, when others are earning 20% or 30% annually. But averaged over time, compared to everybody else during good times and bad, the number starts looking attractive. While the stock market lost nearly 50% of its peak value, I gained. I did so because I never try to predict the future. I would rather be the turtle than the hare when I cross the finish line.
The reality of random walk theory exposes the structural fraud of Wall Street. But we tend to resist the message so elegantly put forth by Malkiel because all of us so desperately want to believe that something about the future can be predicted. After all, you can "predict" that the sun will rise in the east tomorrow morning. But in fact that is not a prediction of the outcome of a statistical probability at all; it is the known result of orbital mechanics. Predicting movement in the stock market is entirely different: once you enter the market, at that precise moment you have exactly a 50.00000% chance that the stock will move up or down in price. Nothing you do beforehand, no amount of research, no amount of technical analysis, no amount of wishing upon a star will change that simple fact. But there remains one more important element: when you exit the stock market, you have exactly and precisely a 50.00000% chance that the market will move up or down from that moment forward. Any effort to change that rule of nature, to nudge that 50% mark off center, is completely and hopelessly futile. Try and you will fail. Once you enter the market, you can only know one thing: with time the market will go up or go down. Any statement or claim beyond that is witchcraft, and you can never predict which of the two will prevail for any one stock.
Gurus pretend they can nudge away from that immutable 50% reality, but they are wrong. Absolutely, deeply, inherently wrong. But they keep serving up the nonsense. Here is a direct quote, a sample of the usual claptrap that passes for investment prognostication, from a highly reputable brokerage house, published in late 2007:
Wall Street Gurus Say No Recession in 2008As a new year begins recession fears are looming, but Wall Street gurus remain optimistic about 2008. Despite the subprime credit crisis that contributed to a volatile second half of 2007, the U.S. Economy will beat the odds of a recession, re-accelerate over the course of 2008 and help to stabilize most financial markets, according to Mesirow Financial's fourth annual Investment Outlook. A separate UCLA Anderson forecast suggests that despite rising oil prices, sinking housing prices and a turbulent stock market, the nation will escape a recession in 2008.
Here is a quote from the Herald Tribune on December 25, 2007:
"Some economists predict that the U.S. economy will slide into recession next year. Others expect the nation to avoid recession, if only barely. A few even think the economy will see solid growth."
Need I point out how silly and useless that is? These ridiculous pontifications are typical of the drivel from Wall Street passing as wisdom. As with these pathetic attempts to divine future market movement, all investment strategies are doomed to fail over time because all share the fundamentally flawed notion that the future is predictable. Nothing could be more ludicrous or futile. The future is deterministic, but unpredictable, just like any chaotic system. We will simply never know enough about all variables to make truly useful predictions that will stand the test of time. What passes now for strategy, research, investment systems and wealth-building methods are nothing better than reading tea leaves or the pattern of scattered bones. If you doubt this truth, find me one analyst, one money manager, one investment guru who five years ago predicted the economic implosion of 2008, or that stocks would decline by nearly half of their peak value.
Equally maddening are "expert" explanations ex post facto of why the market moved in a particular direction. Let's say new unemployment figures are to come out, and are widely expected to push the market down. But instead the market reacts by going up. The self-proclaimed "analysts" will say, with no hint of irony or embarrassment, "The market had already anticipated the bad news." But if in fact the market had gone down, those same experts would claim brilliant predictive powers, and conclude that bad employment news "caused" the market loss. No matter what happens, these charlatans can create any explanation they want to fit the know facts. The analysis is truly useless.
The utter futility of trying to foresee the future has not stopped traders and brokers from creating ever more sophisticated methods that rely on predicting market movement. The urge is too great to resist. So this tragic flaw, this inability to recognize that the future will never be predictable, is often masked by confusing terminology and complicated math to create a comforting image of some higher knowledge. But no matter how clever the system or elaborate the math, or charismatic the money manager, the future simply can not be foretold. How can you predict market movement when you are unaware of trillions of dollars of credit default swaps hidden off-book? How can you anticipate future pricing when you do not know if the Chinese will invest $2 trillion to shore up their own faltering economy in a desperate attempt to prevent political unrest, versus investing those funds in U.S. Treasuries? And those are just two unknowns out of thousands.
If you evaluate the validity of an idea by who subscribes to the concept rather than on the merits of the argument, allow me to invoke Warren Buffet. He said, "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years." Yes, Buffet is supposed to be the poster boy for technical traders using past performance to predict future movement. But that is just another myth. Both he and George Soros repeatedly emphasize that making predictions about the market or the economy has absolutely nothing to do with their success. If you doubt me, allow me to quote further from Mr. Buffett:
"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years."
"If past history was all there was to the game, the richest people would be librarians."
"Our favorite holding period is forever."
That last quote is pure random walk. As with the bible, others can find competing quotes. But his sentiments here are perfectly clear. Making predictions about the future is a loser's game.
If you have had enough of Wall Street's corruption, are tired of imploding markets, and can stomach no more the talking heads spewing nonsense about market movement, then go find a copy of Burton Malkiel's book. Everything you need to know is contained within. You cannot predict the future, and any and every attempt to so will fail. That is a fundamental truth, and nothing you do will ever change that fact. The future is unpredictable. That is a fact of nature, an immutable reality that cannot be altered. Wall Street fraudulently says otherwise. They are deeply, purely, absolutely wrong. Confidence in the market can never be fully restored until this truth is openly acknowledged. We are otherwise living a lie, and that is no foundation for a prosperous future.
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"Greed + Incompetence + A Belief in Market Efficiency = Disaster"
This is the from a quarterly newsletter about the the financial crisis from Jeremy Grantham, Co-Founder and Chairman of GMO, which manages approximately $120 billion.
Here is the portion most powerfully denouncing EMH:
"Never underestimate the power of a dominant
academic idea to choke off competing ideas, and never
underestimate the unwillingness of academics to change
their views in the face of evidence. They have decades
of their research and their academic standing to defend.
The incredibly inaccurate efficient market theory was
believed in totality by many of our financial leaders, and
believed in part by almost all. It left our economic and
governmental establishment sitting by confidently, even
as a lethally dangerous combination of asset bubbles, lax
controls, pernicious incentives, and wickedly complicated
instruments led to our current plight. “Surely none of this
could happen in a rational, efficient world,” they seemed
to be thinking."
http://www
Paul Tudor Jones is the Tiger Woods of technical analysis investing, Buffett is certainly not.
Jones makes for a great "poster boy" for the technical traders out there trying to beat the market (most won't, and the ones that do are, on average, far more talented than the ones that don't).
So, your advice to not try and beat the market is actually great advice for the vast majority of investors in the world.
Likewise, it would be great advice for the careers of most budding biology students with an interest in curing cancer that they can't possibly cure cancer, but I sure hope that lots of curious biology students try, and one day one may succeed.
One has to dream big to do big things, and take on the commensurate risk of failure.
"Yes, Buffet is supposed to be the poster boy for technical traders using past performance to predict future movement."
Actually, Buffett is definitely not the poster boy for technical traders. His trading has nothing to do with price action. He picks stocks. Yes, he repeatedly says that he is not trying to predict the overall market direction, in fact, he claims the he cannot, if I am not mistaken.
However, it is very clear that his stock purchases are predictions of which stocks are better-than-average long-term picks (5+ years). And yes, his favorite timeframe is forever precisely because he hopes that his picks continue to look good like great investments so that he doesn't have to figure out when to sell them.
I'm going to put my money into something less risky like Dutch tulip bulb futures or Nigerian e-mail scams.
Gary Shilling is one of the few that nailed 2008.
The problem here is how would one have known to listen to him, and ignore the majority of economists and market pundits that were obviously more optimistic.
(Hard to be more pessimistic than Shilling in January 2008)
http://clu
See Jeff Schweitzer's Profile
The question is not if Shilling nailed 2008, but if he has a consistent history of accurate predictions that stand the test of time. One win is nothing but the blind monkey throwing darts.
Yes, in fact, almost nobody was listening to him, because his track record of forecasts was actually quite poor prior to his nailing it in 2008.
However, a blind monkey couldn't have detailed the *reasons* for the awful things that happened to us in 2008, which he had been warning about for many years.
Although I'm neither an economist nor biologist, I find that Jeff and Nudger make convincing arguments. It's a crap shoot unless you have insider information.
I have many axes to grind.
Some nicely correspond to things that seem to make you very upset:
Wall Street is very good at enriching its leaders at the expense of Joe Q. Public.
Pundit prognostications are at best useless, and probably damaging to those that attempt to make decisions based on them.
Commission-based brokerage compensation creates vile conflicts of interest.
Others you don't agree with, but notice how close we are to actually agreeing.
Virtually all existing predictive methods are useless for predicting the direction of stocks, but there are exceptions.
Risk management on Wall Street is hopelessly broken, we need much better methods, and I, for one, am not going to keep looking to the financial academic community, because they have failed so dramatically for so long.
From Wikipedia:
'Warren Buffett has commented that “I’d be a bum on the street with a tin cup if the markets were always efficient”
Buffett has picked stocks that have soundly beaten the market for forty years.
See Jeff Schweitzer's Profile
That is the myth, but like with all myths the reality is different. I direct you to quotes from Buffett himself. And let's take George Soros, another billionaire who people incorrectly assume is good at predicting the future. As with Buffett, he will tell you that you cannot predict the future. (I met Soros several times when I was working at the White House). He made his billions partly by exploiting a flaw in the currency market, using arbitrage, where he could buy a currency at one known price in one market and immediately (instanteously) sell it at a higher known price in another market (for example) without taking any risk. Note that nothing about that requires a prediction about the future. Buffett, Swensen and Soros have no crystal ball, period.
Following your advice, I found two more interesting counter-EMH quotes from Buffett in addition to the one I posted above.
At the end of an interesting speech that Warren Buffett gave at Columbia University in 1984, he said the following near the end:
"There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper. "
From: http://www
And, from the only authorized biography of Buffett, actually referring to that 1984 speech:
"Now, to the Grahamites' relief, Buffett had used numbers to disprove the absolutist version of the efficient-market hypothesis
I suppose it is easy to make the following conclusion regarding beating the market:
Since there are many brilliant people who claim that the market cannot be beaten, then there is nobody that can beat the market.
Here are three statements.
"You can make money playing golf."
"One can make money playing golf."
"One can beat the market actively investing.
The first statement is probably false, but not definitively so (depends on who "you" are!).
Therefore, the second statement is, in fact, true.
The third statement is also, in fact, true.
Almost all that try to beat the market do not over a a significant amount of time.
However, some do resoundingly beat the market, despite the Efficient Market Hypothesis which came from brilliant academics who, as it happens, cannot beat the market, and are only willing to admit that fact without saving face by attempting to point out that nobody can beat the market.
I have met some very successful billionaire traders, and, I will tell you, they know quite well that EMH is wrong. They have beaten the market so resoundingly that they just laugh when EMH is brought up. They just laugh!
I realize that many feel that Wikipedia is unfailingly accurate or more accurate than EB, EA, World Book, Encarta, etc. I too rely upon Wikipedia for I'm cheap & lazy. There are those who feel that often Wikipedia often is inaccurate &/or biased [choose a left wing or right wing bias & there will be a Wikipedia critic to prove it]. Check it out on Google or the search engine of your choice; you'll find references & links to Wikipedia's critics plus many charming rendering of JW's name. Finding faults with Wikipedia is a cottage industry.
Don't be surprised if somebody shoots you down for citing Wikipedia or cites an earlier quotation from Wikipedia which disproves your citation. Wikipedia can be wild. You may want to use 2 or 3 sources in addition to Wikipedia to be more sure. Then there is the fact that one can nearly always cite a source which will disagree with any source you may use.
At the core of Malkeil's book is the observation that events (stock market related and otherwise) are fundamentally random. This is apparently very difficult for humans to accept, as we tend to seek an immediate and identifiable cause for every effect we see, and believe that we have much more control over events that is actually the case. Otherwise said, our thinking is deterministic, in a world that is probabilistic.
The question of why we're left with this blind eye towards randomness is an interesting and profound one. Some evolutionary biologists see it as an artifact of a survival approach that worked well when decisions were simple (e.g. fight or flee), and quickly seeing patterns (even when there where none) allowed us to avoid potential danger and live another day. That was fine for getting away from the sabre-toothed tiger and back to the tribe, but is less effective in a globalized economy with 6 billion moving parts.
The bottom line is that we - the human race - are simply genetically underequipped to deal with the complex, random world in which we find ourselves.
See Jeff Schweitzer's Profile
You are right, and you are now getting into my real area of expertise. I am an evolutionary biologist by training. We tend to see patterns where none exist. The nickel version of why: not seeing a pattern that really does exist is more dangerous than imagining one that does not. In other words, a false positive is less threatening to survival than a false negative. (For my biologist friends out there -- yes, yes, I know, that sounds suspiciously like pop evolution; this is a blog, not an academic text). We truly have a hard time understanding and accepting randomness - of the economy, of life, of the universe. Our approach to stocks and investments is just one small reflection of that human trait.
Thank you for your post; always a pleasure to hear this from others.
I am confused as well. Are you saying that there are no patterns that give a person an edge in predicting the future? This seems like such a black-and-white (binary, if you will) interpretation of the concept of prediction.
Are you saying that if a predictive model isn't always perfectly correct, that it is worthless?
What about 24-hour weather forecasts?
How about pregnancy tests predicting the future better than random?
We also (almost) have OSTP as a connection. I took a leave from Los Alamos to work there (Keyworth - Reagan) - but Jay quit just as I moved to DC in 1984, so I joined the consulting company he started. Looking back, that was a classic example of the sort of random event that our (very human) connect-the-dots engine tries to paint as a calculated step in a determined path. Which it of course wasn't - I ended up in business mostly because I spent money on two suits, and I liked the offices in the (then new) Washington Harbor.
The false positive vs. false negative characterization is exactly right. In fact, if you look at the history of chance and probability, it wasn't that long ago that we came to even appreciate the implications of asymmetric outcomes (cf. Pascal's wager) - i.e. being able to weigh not only the odds of something happening, but whether a particular outcome (e.g. false positive or false negative) is more or less to our advantage. We are probabalistic naifs, and that may well be our doom.
Great Post, thanks! Giant Crap shoot, developed for the House. If it wasn't so devastating this would tickle my funny bone. China is good at forcasting, "witch Craft" centurys of culture in this direction, is well ingrained. The big problem I see is, we make it an industry, to verify the pratice, of plain old gambling. The "Beautiful Minds" get creativety confused, with absolutes. Wall St. is fun if it doesn't kill you.
"Either way, as the saying goes, it’s tough to make predictions, especially about the future."
That is one of my favorite sayings that I last read here(hope it still works);
"Fixing cracks in the crystal ball"
Copyright The Financial Times Limited 2008
Published: December 22 2008 20:06
http://www
Much of what you write is true for stock pickers - they don't do as well as the indexes, largely because the indexes deliberately drop the losers and add new winning companies - just check the composition of the Dow Jones Industrial Average, and try to find any company that was in the average 50 years ago.
There are also many global issues - such as currency valuation, which affect stock prices. $1 in 1970 is not the same as $1 in 2009. Making a few % per year is not going to keep up with the reduced buying power of the dollar. Instead, buy inflation protected bonds from the U.S. Treasury.
But successful traders (probably less than 5% of those who try) are winners because they use the statistics, rather than tilting at them. In my town, if the wind is blowing 25 mph from the south west, the odds are good that it will still be coming from the south west over the next 10 minutes. Not a prediction, but the odds are good, and a trader takes advantage of those kinds of odds. Also, price movement distributions are not gaussian, but have "fat tails", so with less than 50% winners, a trader can make a good living. Of course, they won't work as brokers, and won't run large funds. They trade for a living. And make money off those who throw darts.
See Jeff Schweitzer's Profile
Using meteorological analogies does not work, and certainly not for predictions about a future five minutes ahead. Neither has anything to do with stock analysis. Statistics are useless in predicting the movement of any stock; the only statistics will demonstrate is that a stock has a 50% chance of moving up or down at the moment you buy and from the moment you sell. What statistics predicted the collapse of 2008?? I agree there are indeed many global issues impacting the price of stocks, and you will never understand or know all of them, nor the enough about the ones you do know about. Price movements do not usually have "fat tails" as you say; that is just false. You confuse winners and losers with price movement and the two are independent. Finally, of all traders, brokers make the least off of those throwing darts and buying and holding.
A "fat tail" is, almost by definition, fairly rare. However, stocks and stock indices do have fat tails. The distribution of daily percent returns on the S&P 500 over the past year, or ten, or fifty is most definitely not a normal distribution and has a kurtosis much higher than a normal distribution.
If statistics cannot be used to gain an edge in the market, that does not mean that they are not somewhat predictable.
See Jeff Schweitzer's Profile
Concerning your comment about stocks versus indices. The fact that indices drop losers exactly proves my point, not yours. Unless you accurately predicted beforehand what those losers would be, your point is completely invalid. All the indices are doing is ex post facto clean up, which does you no good if you are trying to make money in the market.
You're confusing some things. If it were a true 50/50 random walk, you'd be just as likely to lose with the dartboard approach as win. Since you're more likely to win, there is actually a greater chance of prices going up on any given day (in the long run). At the very least, there's inflation.
See Jeff Schweitzer's Profile
Not quite. By holding long-term and making no attempt to predict the future, the only aspect of the future you deem reasonable to assume to know something about is that the economy will grow over time, averaged over periods of contraction and expansion. There is absolutely NOT a greater chance that prices will rise versus fall for any one given stock.
Sorry, I don't understand. The mean value of a (symmetric) random walk process is the starting point. The way your assumption that the economy will grow over time manifests itself is that the price of stocks will increase. (The *variance* of a random walk -- long-term volatility -- increases over time, but that doesn't help you if you're holding onto the same portfolio long-term.
The only caveat is that prices have a floor, not a ceiling, and that changes the behavior when stocks are near zero value (I don't think that's enough to explain the long-term trend though).
I've always likened the market to playing Red/Black, Odd/Even at the roulette wheel, a sucker bet, its success dependent only on when you stop. It seems I was right.
You must have missed the disclaimer presented by every broker in the world: past performance is not a guarantee of future results. This isn't a revelation to anyone that can read.
It's not merely that there's no guarantee, it's that there's no expectation. Fund management is about providing employment for fund managers, not benefit to customers.
bingo!
LOL! That explains the 2% management fee. It's not like these fund managers want to take any risks themselves
See Jeff Schweitzer's Profile
No, I did not miss that. But if brokers believe that, or their traders did, then why would they do technical analysis to try to divine future movement from past performance? All they are doing is covering their behinds against future lawsuits while pushing the very methods they warn against. If everybody believed the standard disclaimer, which they should, then everybody would be using the random walk method, which they are not.
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