The Futility of Forecasting
Having established that most investors—professional and amateur— underperform the market, the obvious question is, why? After all, professional investors are, for the most part, intelligent people. Just about all of them have college degrees, some from very prestigious schools, and they are required to pass multiple licensing examinations before being allowed to invest clients’ money. Similarly, there are a lot of very smart amateur investors out there. As I noted earlier, I have degrees from Harvard and MIT and successfully built up my own busi- ness, yet I struggled for a long time to beat the market. How can so many smart people fare so poorly?
Well, for the first—and perhaps greatest—reason, we don’t have to look far: It is the fact that we are human. Our own humanity—the way we think, the way we perceive things and feel emotions—has become a major topic in the investing world in recent years. There are even branches of science—behavioral finance and neuroeconomics—that examine how psychology and physiology affect the way we deal with our money. And, in general, the findings show that we humans are investing in the stock market with the deck stacked against us.
Some great research into this topic has been done by Money maga- zine writer Jason Zweig (no relation to Martin, another of the gurus you’ll soon read about), who last year authored a book on neuroeco- nomics titled Your Money andYour Brain. One of the main points Zweig stressed is that human beings are excellent at quickly recognizing
patterns in their environment. Being able to do so has been a key to our species’ survival, enabling our ancestors to evade capture, find shelter, and learn how to plant the right crops in the right places. Zweig further explains that today this natural inclination allows us to know what train we have to catch to be on time, or to know that a crying baby is hungry. Those are all good, and often essential, things to know.
When it comes to investing, this ability ends up being a liability. According to Zweig,“Our incorrigible search for patterns leads us to assume that order exists where it often doesn’t. It’s not just the barus of Wall Street who think they know where the stock market is going. [Barus were divinatory or astrological priests in ancient Mesopotamia who declared the divine will through signs and omens.] Almost every- one has an opinion about whether the Dow will go up or down from here, or whether a particular stock will continue to rise. And everyone wants to believe that the financial future can be foretold.” But the truth, he says, is that it can’t—at least not in the day-to-day, short-term way that most investors think it can.
You don’t have to look too far to find that Zweig is right. Every day on Wall Street, something happens that makes people think they should invest more money in the stock market, or, conversely, makes them pull money out of the market. Earnings reports, analysts’ rating changes, a report about how retail sales were last month—all of these things can send the market into a sudden surge or a precipitous decline. The reason: People view each of these items as a harbinger of what is to come, both for the economy and the stock market.
On the surface, it may sound reasonable to try to weigh each of these factors when considering which way the market will go. But when we look deeper, this line of thinking has a couple of major problems. For one thing, it discounts the incredible complexity of the stock market.There are so many factors that go into the market’s day-to-day machinations; the earnings reports, analysts’ ratings, and retail sales figures I mentioned above are just the tip of the iceberg. Inflation readings, consumer spending reports, economic growth fig- ures, fuel prices, recommendations of well-known pundits, news about a company’s new products, the decisions of institutions to buy and sell because they have hit an internal target or need to free up cash for redemptions—all of these and much, much more can also impact
how stocks move from day to day, or even hour to hour or minute to minute. One stock can even move simply because another stock in its industry reports its quarterly earnings.Very large, prominent com- panies such as Wal-Mart or IBM are considered bellwethers in their industries, for example, and a good or bad earnings report from them is often interpreted—sometimes inaccurately—as a sign of how the rest of companies in their industries will perform.
What’s more, when it comes to the monthly, quarterly, or annual economic and earnings reports like the ones I’ve mentioned, the mar- ket doesn’t just move on the raw data in the reports; quite often, it moves more on how that data compares to what analysts had projected it to be. A company can post horrible earnings for a quarter, and its stock price might rise because the results actually exceeded analysts’ expectations. Or conversely, it can announce earnings growth of 200 percent, but fall if analysts were expecting 225 percent growth.
Finally, let’s throw one more monkey wrench into the equation: the fact that good economic news doesn’t even always portend stock gains, just as bad economic news doesn’t always precede stock market declines. In fact, according to the Wall Street Journal, the market performed better during the recessions of 1980, 1981–1982, 1990–1991, and 2001 than it did in the six months leading up to them.And in the first three of those examples, stocks actually gained ground during the recession.