Probability and Prediction in the Markets

“Allied to the foregoing is the record of the published stock market predictions of the brokerage houses, for there is strong evidence that their calculated forecasts have been somewhat less than reliable than the simple tossing of a coin.”- Benjamin Graham, ‘The Intelligent Investor’ (1949).

This insight from Ben Graham in 1949 is an important reminder for investors and traders in the 21st Century. I sum it up as: never predict a market. In our digital age we see so many people trying to predict things, particularly from economists who love to predict. Seasoned investors or traders know differently- markets can do nearly anything.

The line is quite fine when it comes to decision-making. If we make an investment in stock ABC at price X, and naturally we are long, we anticipate price might increase in the future. Note the key words of ‘anticipate’ and ‘might’. We do not predict price will rise from X because we accept the premise markets can do nearly anything. We know and believe no one tool or method or system can guarantee anything in terms of price movements in the financial markets.

Novice investors and others think differently. They believe a collection of variables, be they technical, fundamental or otherwise, can come together an predict the future of a market or a stock price in that market. Too often the market proves them wrong- the evidence is as clear today as it was in 1949.

Seasoned inventors embrace the ‘might’ and do not accept that price ‘will’ do anything. We think in terms of probability and scenarios. For instance, if price moves from X up to Y then our investing/ trading plan will guide us to take certain action. Similarly, if it moves down to Z, our plan might trigger a stop loss and we may close the position.

We accept therefore there is ‘no right or wrong’. It is just probability and scenarios. We can easily accept this because we made no predictions in the first place.

This has an important psychological consequence. Newcomers to the markets are often the loudest predictors. When their prediction does not work out, they feel they are ‘wrong’, they have made ‘bad mistake’ and the loss hurts. More experienced investors or traders side-step most of this, because we never felt we were wrong in the first place. We accepted a probability framework, assessed the scenarios, and followed the rules or guidelines in our plans. Losses then are expected as simply a cost of doing business.

In your own journey as an investor or trader, a good litmus test is whether you are still thinking in terms of right and wrong. If a position goes against you, what questions immediately come to mind? Do you beat yourself up because you were wrong? Do you try to find errors to create the next ‘perfect’ trade or investment? How do you perceive the loss? How does it feel?

None of these psychological questions are easy at first. In time, if you stick at it, as you move towards a probability framework in your thinking. Then things will become much easier. Time and experience at the coalface of the markets is the only trusted way forward. So allow yourself this time to learn your craft. Allow yourself to become a true professional.

Lee Spano, Founder & CEO

Creatness International, www.creatness.com

© Copyright Lee Spano. All rights reserved.