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Predicting the Market

February 24th, 2007 at 06:09 am

No matter whether you've been investing for a day or a decade, there's always the niggling thought that someone out there knows the "secret" to timing the market. So you may give your money to a professional to manage (eg. Actively Managed Funds), or read books or take courses on a technique to boost your returns above the market average. All these things will cost you time and/or money. Occasionally one method you try for a while (day/month/year) will actually produce good results, so you'll tend to think you've discovered the "secret" and stick to that method until it ultimately fails (and in the meantime possibly blog about it, tell your friends, write a book, or teach your "secret" in seminars).

I must admit that I've done this over the years, and I still will invest a portion of my money using particular techniques in attempt to boost returns - for example my "Little Book that Beats the Market" US Stock Portfolio (Value Investing), and toying with the idea of moving some of my domestic stock investments from my geared personal stock portfolio (stock picking) into a professionally managed individual stock account (with Direct Portfolio) within a self-managed super fund (SMSF). But my preference over time has shifted towards low-cost index funds where available (I'm thinking of moving my retirement account from my employer's default fund (Westpac/BT Employer Super) into a SMSF where I can invest in Vanguard Index Funds or ETF such as the Commonwealth Diversified Share Fund (CDF)

One of the main reasons I've drifted towards a preference for Index Funds is that although I recognise that some actively managed funds outperform for extended periods (eg. Berskshire Hathaway), most funds that outperform for a while (up to a decade) can be simply put down to "luck" or random chance. Similary, techniques such as charting, while always able to explain stock movements in hindsight, don't appear to have any real predictive power. If you ever need reminding that a LARGE component of stock price variations (and market variations) is purely random, despite the appearance of clear patterns or "trends" in the charts, just do a simple random walk simulation in excel.

For example, just as a reminder to myself, I ran a simulation in excel to model the coming year in the ASX All Ords using a few basic parameters and a random number generator:

Simulation Period: Daily Index Value for next 250 days
Starting Value: 5800 (around the current Australian market level)
daily movement formula: new value=P+(10%/250)*P+RAND()*200-100
where P=previous cell's value (eg. B4, if calculating value for cell B5)
I picked an overall 10% pa ROI as a typical stock market trend and a daily random move of + or - up to 100 points as a fairly "typical" market movement.

It's amazing how realistic the "chart" for this simulated market is every time you press F9 to recalculate the random numbers. For example, just from random numbers, you can get a continuing "bull market", a sudden "crash", a "bear market", or a "correction":
Bear Market:

Bull Market:

Correction:

Crash: (just a little one)

Of course the market (and individual stock prices) isn't purely random - but key events that will shift the market in a particular direction by a significant amount aren't known in advance (otherwise the effect would already reflected in the price by other investors trades adjusting the price level).

Ultimately, I think the time spent trying to uncover "secret" techniques to predict the market would be better spent by a novice investor in a second job earning more funds to invest, and for a more seasoned investor with a significant amount already accumulated, just concentrate on diversification, asset allocation, tax-effective investment structures and try to avoid high fees, churning or other return-diminishing behaviours.

1 Responses to “Predicting the Market”

  1. scfr Says:

    Great post. I agree 100% with the last paragraph, and would add that time could also be well spent learning about finance (to avoid being scammed, etc), learning money-saving techniques, or starting a business. All with the goal of having even more money to sock away in those investments.

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