The Prediction Game
In today’s globalised and hugely efficient financial world, where trillions of Dollars and Euros are deployed in nano seconds, you are competing with the biggest investment banks, asset managers and hedge funds with their thousands of traders, analysts and Nobel Prize winning intellectuals. It takes much hubris to believe that you are going to be smarter than everyone else (and make money). Nonetheless, we come across many people that do believe that they can predict the future, and hence we explore here the known and established schools of thought to make an investment decision:
1. Macroeconomic – The great advantage of the study of economics is that you can hold everything else constant. This way, you can isolate the relationship between inflation and unemployment for instance, allowing you to make inferences or establish causal effects. But in the real world, where everything is linked, nothing moves in isolation, and where you have to analyse the relationship between hundreds of different factors simultaneously, making forecasts is infinitely more complicated. Then, there is time. It is generally known that it takes about six months before economic effects filter through to the real world. During this time, there are literally millions of random events that can impact or alter those same effects. The track record of using macroeconomic factors to predict future performance is accordingly very poor. Of course, you can get lucky and this is the argument I always get: people point to the one view they got right. But what about all the other ones they got wrong? And by the way, a coin flip can also come up heads 9 times in a row and it doesn’t mean it’s going to come up tails on the 10th flip, as a matter of fact it doesn’t mean anything.
2. Fundamentals – When investing according to fundamentals, the problem is the same as with macroeconomics: it takes months for things to change. Not only because the indicators get published only quarterly (at best), but also because people have to take them into account. They have to analyse, then change their view and finally also change their allocations. And you just don’t know when people are going to wake up to the same view that you took. You may think a company is undervalued but if the market doesn’t agree, it will stay undervalued for a very long time. The funny thing is, we can probably all agree when a stock or a market is under or overvalued, after all we have the same numbers that back up those cases. But if you do want to employ this strategy, prepare yourself for some pain if things take longer than expected. Timing is a female dog, as we used to say on the trading floors, and nothing is more frustrating when you know you are right, and going bankrupt waiting for everyone else to agree.
3. Technicals – It seems hilarious that we think that by drawing a few lines into a chart, we can somehow figure out where a security is going to go. But the fact is, everyone looks at technicals. We all like to look at charts and if we all believe they work and trade accordingly, it becomes a self-fulfilling prophecy. I have seen people go mad with technicals: head and shoulder patterns, break outs, Fibonacci, Bollinger Bands, relative strength indicators, oscillators. There are whole books written on technical analysis. Again, the point is this: it will only work if others see the same thing. If you have some super complicated chart analysis and nobody else gets it, it won’t work – so keep it simple and work with tight stop losses. I have seen many people who are so in love with a chart, that when it turns against them they look for other reasons to stay in a trade (oftentimes they then refer to fundamentals, which is amusing). The most effective way to use technical analysis is to identify trends, and as long as you see no great reason for things to change (losing momentum, resistance lines), the trend is your friend and you can ride investments very effectively.
4. Quantitative models – I have to admit, I came late into using quantitative models. I still remember when some long-haired hippy, with flip flops and a PhD of some sort, walked onto our trading floor and proudly proclaimed he was going to make $300m next year (having never traded before). We took little notice until three years later this same hippy (now with short hair) had made more than $1bn in profit for us and was made a Managing Director. In any event, the great advantage of using quantitative models is that it allows you to broaden your scope by being able to crunch thousands and millions of data points that you can’t do as a human. It also forces you to be consistent, and consistency is the name of the game. Whatever you do, you have to stick to what you do. If there is a technical break don’t change to a fundamental view, if you have a stop loss, stick to it. You need rules in trading and building a model forces you to a) articulate those rules and b) allows you to (back) test them to see if they work.
So, what is the effectiveness of all of these great methodologies, studied, practised and employed by millions? Turns out not very high and why would that seem surprising, nobody can predict the future. If we could, we would probably live in some never-ending loop of 'back to the future' and quite literally go interstellar. So why does everyone do it? I think it’s because you have to do something. We get a sense of assurance when we have crunched some numbers or listened to some ardent intellectual giving us their highly educated views on the world. Fact remains, it’s all random, it’s all luck and you are much better off diversifying across assets that behave differently and letting things grow. The less one tries to 'add value' the better, and the money you save on not paying someone to predict the unpredictable can go a long way to fulfilling all of your investment needs.