Why can’t people do a better job predicting the stock market? It isn’t just ordinary folks like you and me that have problems. Even the experts get it wrong about as often as they get it right. How hard can this be?
It turns out to be very hard. We don’t have a reliable way to predict stock prices — and we never will. The reason can be found in something I call the prediction paradox.
The traditional explanation of randomness in prices is that investors take into account everything that can be predicted about a company in deciding how much to pay for its stock. When the stock price reflects everything that can be predicted, the price will change only in response to things that cannot — so changes will be random.
That’s a powerful concept. It tells us that even if we get better at predicting how companies and industries and the economy are going to perform, we still have to expect random variation in stock prices. There will still be a residue of unexpected events that will call for price adjustments one way or the other.
There must be more to the story, though. It seems as if we should be able to take advantage of situations where investors fail to arrive at a proper price for a stock. They can’t be right all the time. As Lawrence Summers, now serving as Director of the National Economic Council, once said said in an informal paper, “THERE ARE IDIOTS. Look around.”
The Summers quote is taken from The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street
The paradox
Here’s the problem in trying to take advantage of pricing errors in the stock market. Let’s assume there’s a reliable way to know ahead of time when a stock price is going to fall. And let’s assume the method is available to investors in general, because if it isn’t, then it may as well not exist for ordinary folks like you and me. Using this method you find out that one of your stocks is about to decline in value, so you want to sell it right away. Who will buy it?
The stock market isn’t a dumb beast waiting to accept our orders to buy and sell. It’s a place where investors buy from and sell to each other. And if there’s a reliable way to know a stock’s price is going to fall, and this method is available to investors in general, they’ll use it to avoid buying that stock at the higher price. The existence of a reliable prediction eliminates buyers at the current price, making the prediction worthless.
This is the prediction paradox, and it’s a major theme of my book, That Thing Rich People Do. It applies to many aspects of investing besides stock prices. It tells us, for example, that we shouldn’t expect to find a reliable way to know in advance which mutual funds will perform best. We become better investors when we develop a habit of thought that makes us skeptical of predictions about investments. We need to ask ourselves, ”What would have to be true if this were known to be a reliable source of predictions?” In many cases the answer is that the prediction would be self-defeating.
Tags: feature
