No One Can Predict the Stock Market...

... Including me.

When I first became an investment advisor thirty years ago, I actually had a brochure with that slogan on the cover. I hadn't been in the business very long but I already knew it was true. I had become a believer in what is known as "the efficient market theory," which basically says that all publically known information is already reflected in the current price of every stock. Almost forty years in the business have, if anything, solidified that belief.

And yet millions of people search for the advisor, mutual fund manager, or newsletter that can consistently "beat the market." And there have been many "Wall Street Gurus" over those forty years who built track records that, at least for a season, seemed to indicate that they could "beat the market." Let me explain what I think causes this.

Imagine that there are 100 people sitting around a very large poker table, all of equal poker playing ability. If we play for one night, there will be fifty winners and fifty losers, simply based on luck. If we all get together for a second night, there will again be fifty winners and fifty losers. And simply be the laws of chance and probability, 25 will have won both nights, 50 will have split, and 25 will have lost both nights.

If we keep meeting, by the time we get to Night 5, the results will look something like this:

Won 5 Lost 0 -----> 3 people
Won 4 Lost 1 -----> 15 people
Won 3 Lost 2 -----> 32 people
Won 2 Lost 3 -----> 32 people
Won 1 Lost 4 -----> 15 people
Won 0 Lost 5 -----> 3 people

Now remember, my premise is that all 100 players were of equal ability. If you try flipping a coin five times, and repeat the process 100 times, calling heads a win and tails a loss, this is what your results should resemble.

So based on nothing but "lucky cards," we would have three people who would begin to gain a reputation as being better players, or having an edge. In my view, this is exactly what happens on Wall Street. When I first became a broker in the 1960s, the lucky winner's name was Joseph Granville, who developed a large following and for a couple of years could cause pretty substantial market rallies or declines just by making a bullish or bearish comment. In Granville's case, which is typical, his fame was cut short by some spectacularly bad predictions, and the Wall Street crowd moved on to their next darling.

Now the above phenomenon is a pretty well kept secret on Wall Street, because it's not good for business. How can you recommend a mutual fund or some other investment if nobody really knows what's going to happen? Would you gain or lose confidence in your mutual fund if you knew that 90% of equity mutual funds did not "beat the market" over the past ten years. In general, their average return is about equal to the return on the appropriate market index minus their fees and expenses. What a surprise!

For this reason, many people turn to "index funds" or their equivalents, with a goal of matching as close as possible the return on that index. And the good news is, that's still pretty good! Thanks to the juggernaut US Economy, the average return on the American stock market for the past 100 years or so has been in the vicinity of 10%. And that is the big difference between stock investing and my poker table analogy.

You see, poker is an example of what would be called a "zero sum game," that is, no money is created at a poker table. It just changes hands. So average equals a zero percent return. But stock investing averages a 10% return, so average equals a 10% gain, and a "loser" might still average 5%.

There are many other implications of this phenomenon, and many other legitimate ways to try to enhance one's returns. But if I gave them to you all in one night, you wouldn't have any reason to check back here regularly, now would you? :-) Bob


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