Making Probability Theory Practical for Investment

Making Probability Theory Practical

One of my favorite sayings is “Anyone who tells you they know what the stock market will do in the short term is either a fool or a liar”. The market cannot be predicted on a daily, weekly, monthly or yearly basis. This is NOT true for long periods of time; but we will talk about that later.

Probability Theory Illustrated

So how do some people correctly predict short term movements with great accuracy? Let’s look at probability theory illustrated in a simple example. If you flip a coin you have a 50% probability of heads and a 50% probability of tails. If you ask 1000 people to predict the outcome of a single coin flip the probability is 50% will predict correctly and 50% will get it wrong. Flip the coin twice and the odds are only 25% of predictors will guess both flips correctly. The accuracy will fall with each additional coin flip. At the end of 10 coin flips the odds are 1 out of 1000 will have predicted every coin flip correctly. Is that person the best prognosticator? These are completely random events and the odds were 1 out of the 1000 would get ten correct guesses in a row.

Probability in Investment

Although the stock market is much more complex, the same concept of probability in investment applies. Studies have shown that short term returns in the stock market are random, although with a positive bias. The positive bias is the difference between the coin toss example and the stock market; meaning there will be more positive than negative outcomes over time.

If you have enough prognosticators (and we do!); there will be a few who are able to successfully predict the short term moves in the stock market over several or even many time periods. Unfortunately, people begin to believe the stock market prognosticators are infallible and more and more people follow their advice. The more successful the predictions the greater number of followers. In addition to more followers, investors become more confident in their abilities, and make larger and larger bets. After all, the predictor has been correct many times; they must know more than anyone else? Of course, this is incorrect.

Inevitably the odds eventually catch up with the prognosticator. They guess incorrectly, and many people are harmed. But more damage can be done with a few incorrect guesses than all the correct guesses combined. That is because few are following when the prognosticator first starts his predictions. But at the end many people are following and many will most likely be making much greater bets than they were in the beginning. This is one of the reasons people get disenchanted with investing. They make poor investment decisions; usually based on greed and lack of understanding. They don’t have a solid investment plan.

It is easy to become lazy and attempt to follow an investment guru instead of implementing a sound investment plan. But there are no short cuts in investing. Any investment philosophy that is going to get you rich quickly is a scheme that will end badly.

Fortunately, for those willing to be patient and implement a long term investing plan, probability comes close to guaranteeing positive outcomes for those who do their homework. The stock market can be predicted in the long run.

In my next post, “Investment Decisions: Asset Allocation, Stock Selection, & The Dynamic Duo of Investing” we will look at two investment strategies that increase your probability of investment success to nearly 100%.