Randomness

At the beginning of every year, you’ll find no shortage of pundits attempting to forecast the market for the ensuing twelve months. Each one has their own unique take on what they think will happen, despite the impossibility of actually being able to predict the future. But that’s what they’re paid to do, so one can hardly fault them for it. Upton Sinclair once said “it is difficult to get a man to understand something, when his salary depends upon his not understanding it.” Perhaps these market pundits are failing to understand that world events are random, and these events—to a large extent—drive the direction of the stock market. Therefore, it follows that the markets must be random, at least in part.

Figure 1 highlights just how random the market has been over the 15-year period from 1999 to 2013. Many have been fooled by the randomness of the market, and changes are often made to portfolios at precisely when a particular asset class has nowhere to go but up. For example, in 2008, during the Great Recession, the MSCI Emerging Markets Index lost more in that 15-year span than the other 10 asset classes represented in the figure, falling 53% in one year. If you had sold out at the bottom, thinking that the trend was going to continue into the next year, you would have lost on the 79% gain that followed the very next year; the biggest gain during that time period for any asset class.1 Our guess is that no pundit would’ve seen that coming.

Figure 1. Market returns by asset class, 1999-2013

Just as there is no discernible pattern to the MSCI Emerging Markets Index, the same can be said for the other 10 asset classes in the illustration. The S&P 500 Index, widely considered the market’s bellwether index for domestic equities, has had one-year swings in excess of 30%, 50%, and 63% over the 1999-2000, 2002-03, and 2008-09 periods, respectively. Some time periods of the S&P were in positive territory the first year before going negative the next, while some were deep in the red, like in 2008, subsequently reversing course and posting big gains the following year. The point is that no one knows what the market is going to do on a daily, weekly, monthly, or yearly basis. That’s not to say, however, that we can’t make educated guesses on what the market may do over longer time periods.

We wrote about the intricacies of long-term investing in an article entitled Allocating your hard-earned capital, the smart way. Our premise was that over long periods of time, a portfolio of all equities will yield higher returns than an all-bond portfolio, but with the additional risk of substantial volatility. If less volatility is desired, a portfolio more heavily weighted towards bonds would be more suitable. In other words, general trends over long periods of time do occur, but short-term, technical analysis of price movements in stocks are nearly impossible to anticipate ahead of time with any precision. Long-term trends are good guides by which to construct your portfolio, but only if you’re going to be a net buyer over that time period. If you’re looking to sell in the not-so-distant future, it’s best to preserve the capital you have by allocating more capital towards bonds.

In short, markets are random, leaving investors with limited information on where they will go next. By taking a step back and realizing that the market is much smarter than us, we can be better disciplined to take advantage of the randomness that surrounds us.

1.https://investor.vanguard.com/investing/investment-research