“Past performance does not guarantee future returns”. You might have heard or read this line in stock market many times, especially while buying a mutual fund. What is ironical is that the statement comes after you have been told how well that fund has performed in the past.
If we look at the market history, there are ample evidences proving that past performance is not a great indicator of the future. But why is it so difficult to predict the market, and is there any way to do so accurately?
Challenges in Market Prediction:
Well, let’s first understand the challenges we face while trying to predict the future. There are too many variables to be predicted. Forget about market, imagine trying to predict the next move of a player in the game of chess, there are 10 to 120th power possible moves, that is 1 followed by 120 zeroes.When there are so many possibilities, how accurately can you predict which move will the player choose?
There are so many mathematical, quantitative, historical and even psychic models that have been tried, but none of them has ever been 100% successful. The second biggest challenge in predicting market is our inherent bias.
We believe that a model that has predicted the future accurately in the past will be able to do so in the future as well, but that is no more true than believing me when I tell you that a coin will land heads up just because I accurately predicted it would do so for the last 10 times.
Does that mean we are at the mercy of the market for our returns and trying to predict the market is a game we are almost certain to lose? Well, to a certain extent, yes. There are ways to predict the market but only to the extent that there is no “black swan” event.
The word black swan was coined by Nicholas Nassim Taleb, in his book “The Black Swan:The Impact of the highly improbable.”(I would highly suggest you read this book, it’s a gem).
A black swan event is a highly improbable event that has huge impact and can change the direction in which things are supposed to happen.
For example a good, healthy, developing economy may suffer huge setback as a a result of war or an external threat to its security. Such events are highly improbable and rarely happen, but have huge impact on the growth of the economy.
There is no way to predict if a war may take place, nor there is any way to predict when will it happen.
No financial model whether its based on quantitative analysis, historical events or any other, can predict such events, let alone factor their impact on the market. You simply cannot measure uncertainty, it’s simply un-measurable.
So, what is the solution?
Just because we cannot measure or predict the uncertain events, does not mean that we should give up on market forecasting altogether. What we need to understand is no technological advancement, nor any mathematical or financial model can accurately predict the future.
In my experience, the best way to predict the market is by not trying to predict them. What it means is, treat your prediction as guide to understand what to expect from your investment, do not take them too seriously, rejecting the facts that contradict with your forecast. Investors must develop opposable thinking and avoid choosing one thought at the expense of other. Markets do not know about your forecast, and thus, will never behave or follow the path you have chalked out. The best way to be a successful in market forecasting is to remain humble and make necessary changes to your investment strategy as the situation demands.
Don’t get too emotional about your forecast, they will go wrong sometime, it is this unpredictability of the market that keeps it alive and keeps us on the edge of our seats, and if you think logically, what’s the fun in playing a game that you know you are going to win everytime?
I hope you find this article useful. In the end all I can say is, make logical decisions, don’t let your ego blur your vision of changes that are happening in the market, be humble with your expectations, do not chase high returns, look for decent but consistent returns, and in few years, you will find yourself outperforming most of the “experts”