No one truly knows what tomorrow will bring. Nobody. Any and all forecasts are, at best, educated guesses. All prognostications are instantly stale, subject to further revision. Conditions change, new data are released, events unfold. Yesterday's prediction can be undone by tomorrow's press release. In order to "become right," some investors will stand by their predictions despite a stock or the market going the opposite way, hoping to be proven correct. Ned Davis called this the curse of "being right rather than making money." There are only two kinds of predictions that have some value to investors: One is probability-based, and the other is risk-based. As long as you apply the same rules -- no one knows the future, they are subject to revision and should not be taken as gospel -- then these are sometimes worth considering. Probability assessments are typically based upon historical comparisons of prior markets with similar characteristics: The more variables that align, the higher the likelihood that a given scenario plays out in a similar fashion. They are of this variety: In the past, when X, Y and Z all happened together, then we expect that A is most likely, then B is possible, while C is the least likely.
Chaos TheoryWhy 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|
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Apprenticed Investor series