Apprenticed Investor: The Folly of Forecasting

I engaged in a combination of broader market-based probability this week in Smart Money, along with future risk assessment. Given the change in character the market displayed since the April lows, I noted the high probability of a substantial rally in the second half of the year. My basis for this was part technical -- the market regaining its prior trading range -- and part anecdotal (all the hedge fund cash on the sidelines). This created a high probability of a move similar to what we saw over the summer of 2003.

But I also included a risk-based assessment based upon the age of this bull move, along with the decaying macroeconomic environment; in tandem, they set up an increasing risk environment as the year progresses. That's how a top can form, and that presents an increased risk of a market correction or even collapse.

When you stop to consider all of the unforeseen actions that might occur between now and then, however, it becomes pretty apparent that all forecasting is at best a low probability activity.

Chaos Theory

Why are the markets so difficult to predict? To borrow a phrase from the physicists, the market demonstrates "unstable aperiodic behavior in deterministic nonlinear dynamism."

This behavior is better known as Chaos Theory.

What does that mean in English? The market is called "aperiodic" because it never repeats itself precisely the same way. Weather is also aperiodic -- it may be colder in the winter than in the summer, so there is a degree of cyclicality. But the day-to-day changes are never exactly the same year after year. The same dynamic applies to the markets: There are similarities from one era to another, but it's never identical. In Mark Twain's words, "History doesn't repeat, but it rhymes."

The markets also act with a surprising degree of instability. Small forces can create disproportionately large reactions. A surprising economic report, an off-the-cuff comment by a Fed official, a small change in earnings by any one of 1,000 companies; any one of these data points can roil the market. That behavior does not occur in what the scientists call "stable" systems.

Given the complexity of both the capital markets and the physical universe, we shouldn't be that surprised that Chaos Theory is so applicable to the financial markets.

Considering how little we know about the totality of market conditions -- and how incredibly intricate and complex the system is -- it's no surprise that pundit predictions are so frequently poor.

	1.	Expect to Be Wrong		2.	Your Fault, Reader
	3.	The Wrong Crowd		4.	Bull or Bear? Neither
	5.	Know Thyself		6.	Prepare for Battle
	7.	Bite Your Tongue		8.	Don't Speak, Part 2
	9.	The Zen of Trading
Check back for more of Barry Ritholtz's Apprenticed Investor series