Hi Guys,
Try as we might, it is a challenge to be neutral about the marketplace’s direction. Everyone and his uncle has an opinion, a few more informed than most others.
That’s our forecasting curse, and it often does us more harm than good. We all like to participate in what often turns into a Loser’s Game. One extrapolation of the 80-20 rule can be used to establish the creditability of that argument.
You all are familiar with the generic 80-20 rule. One of its most popular interpretations is that 80% of the work is accomplished by 20% of the folks, or that 80% of an individual’s output is coupled to only 20% of his efforts. Lots of wasted motion.
The 80-20 variation that I want to discuss highlights the futility of forecasting follies. Trying to anticipate market movements rather than simply staying-the-course loses more often than it gains. The behavioral researchers have tested this hypothesis with an experimental game they call Red Light, Green Light.
Test participants in this game are asked to forecast if a random light will be either red or green. They are informed that the light color is randomly selected, but that it will be green 80% of the time. Now they play the game, and their score is recorded.
The expected correct score should be approximately 80%. Just about all experiment subjects fail to achieve that level. They fail because they believe they see a pattern that can be exploited. They are wrong. Here is a Link to a NY Times article that discusses some experimental results:
http://economix.blogs.nytimes.com/2011/02/17/forecasting-is-for-the-birds-and-rats/?_r=0A superior strategy, given that each outcome is randomly independent, is to forecast green every single time. From simple probability theory, if that strategy is used, the player will be on average (1.0 X 0.8) + (0.0 X 0.2) = 0.80 or 80% correct.
Most participants adopt a more complex strategy. Some like to play a strategy that is weighted to the given 80-20 distribution. Again, from a simple probability calculation, the player will on average generate (0.8 X 0.8) + (0.2 X 0.2) = 0.68 or 68% correct guesstimates. This strategy has decreased the odds of winning.
This simple probability analysis demonstrates the power and wisdom of betting on the favorite outcome consistently. Lower level animals learn this lesson quickly. Investors don’t. The strategy of betting in proportion to the frequency of occurrence lowers the likelihood of a successful outcome.
This type of analysis can be applied to the equity marketplace. The historical data reveals that on a monthly basis, equities have increased in value
59.6 % of the time since 19
50. The upward reward happens roughly 70% of the time on an annual basis.
Doing the same analysis for a 70% positive annual equity return yields the following results for the two strategies defined. For the no-brainer who is always in the market strategy, that investor will obviously get positive rewards 70% of the time,
For the more sophisticated investor who plans to be committed to equities 70% of the time and in bonds/cash 30% of the time, his success ratio, on average, is likely to be (0.7 X 0.7) + (0.3 X 0.3) = 0.
58 or
58%. Here again, the frequency strategy is likely to be less rewarding than the always-in strategy.
Unless an investor is prescient or especially insightful or perhaps just plain lucky, his forecasting (likely linked to a pattern seeking and seeing tendency) will probably degrade his cumulative long-term returns. Once again simple beats complex. Or does it?
There is a danger to oversimplifying a problem. I tend to be more or less committed to being in the market. But I do adjust my percentage of equity holdings depending on some measures like overall market P/E ratio. I hold fewer equities when that measure is high. As H.L. Mencken said: “For every complex problem there is an answer that is clear, simple, and wrong”.
Certainties do not exist in the investment universe. So I hedge and broadly diversify. What do you do?
Best Regards.
