Predictions for the stock market surface around the turn of every calendar year. It’s an annual tradition for financial institutions. They can tout their “expertise” to clients and others who want reassurance on how the market will perform over the next 12 months.
There’s just one problem. Market predictions are almost always wrong — spectacularly so. It’s no different from the pundits that pop up every year with their failed claims of impending market doom. Sure, they may get it right eventually, but when the same prediction is made every year it’s no more expert than a broken clock.
Predicting the future is hard. Predicting the future of markets — market crashes much less the general direction of markets — is even harder.
Why is it so hard? Because markets are complex dynamic systems. Much like naturally occurring catastrophes, many complex systems tend toward a state of criticality. Wildfires, earthquakes, epidemics, avalanches, and stock markets are complex systems that self-organize toward a state of instability and sudden change.
A good example of this was found when analyzing avalanches using a sandpile game. Picture a pile of sand. One tiny grain of sand is dropped onto the pile, one at a time, to see how long it takes before the pile collapses. They tracked the frequency and size of each collapse and found the cascades to be unpredictable.
The sandpile naturally organized itself into a critical state where any grain could trigger a cascade of any size at any time. While each grain increases the chance of a cascade, it was impossible to predict which grain would trigger a collapse or how big the collapse would be.
Markets operate in a similar critical state to sandpiles. Even though it’s easy to associate market instability with a crash, the difference, of course, is that a change or instability in markets can lead to sharp rallies or declines. Those rallies or declines are as unknowable as which grain of sand might trigger a sandpile to collapse.
Large fluctuations in market prices seem to result from the natural, internal workings of markets, and so flare up from time to time even if there aren’t any “sources of structural fragility,” or sudden alterations of the fundamentals to set them off. And the reason may be quite simple: markets are not even remotely close to being in equilibrium…
Despite the confident predictions of bulls and bears, and despite what you may read in the newspapers, mathematical analysis indicates that…prices are still just as likely to go up in the near future as down. But this only hints at the true flagrancy of the market’s unpredictability, or, shall we say, its upheavability. The power law for price fluctuations indicates that even the rough magnitude of the upcoming change is unforeseeable. In a market organized to the critical point, even the great stock market crashes are simply ordinary, expected events, although it is true that we should expect them infrequently.
This tendency toward instability is something George Soros discusses in his theory of reflexivity:
The reality is that financial markets are self-destabilizing; occasionally they tend toward disequilibrium, not equilibrium.
The paradigm I’m proposing differs from the conventional wisdom in two respects. First, financial markets don’t reflect the actual economic fundamentals. Expectations by traders and investors are always distorting them. Second, these distortions in the financial markets can affect the fundamentals — as we see in both bubbles and crashes. Euphoria can lift housing and dot-com prices; panic can send sound banks tumbling.
That two-way connection — that you affect what you reflect — is what I call “reflexivity.” That is how financial markets really work.
Soros’s theory of reflexivity paints a better picture of just how complex markets are. Imagine millions or billions of traders and investors pressuring asset prices. Then one slips…leading to a cascade of actions and reactions by those same traders and investors. It takes a special kind of ego to believe that’s predictable.
So what’s the lesson? Market fluctuations are the norm, not the exception. They are unpredictable.
A market decline or rally can be triggered at any moment, without a catalyst, with no way to know when or how long it will last. Markets will shift between moments of calm and wildness.
That may sound scary but remember that despite the unpredictability, and the uncertainty of what comes next, markets have performed exceptionally over the long run. So accept the instability. Embrace it.
Build your portfolio to survive the moments of market instability that are bound to pop up. Then tune everything else out.
Cut out the noise. Cut out the pundits, prognosticators, and doomsayers. Ignore it all. You don’t need to hear any of it to successfully invest in the market.
Source:
Ubiquity: Why Catastrophes Happen
Crisis Is Endemic to the Financial System
Related Reading:
Notes for Ubiquity: Why Catastrophes Happen
The Reminder of Mr. Market