Knowing the future would surely help you outperform the market, wouldn’t it? Probably not nearly as much as you might have thought.
As regular TEBI readers will know, nobody has a crystal ball. Yet every time you open the financial pages or turn on Bloomberg or CNBC, someone’s expressing an opinion about the future direction of the economy or the markets and how investors should position their portfolios. Even now, there are still financial advisers and investment consultants who like to give the impression they know what’s coming.
But let’s play devil’s advocate for a moment. What if you really did know what the future holds? Would it actually help you to achieve better investment results? The academic evidence suggests that 20/20 foresight is much less helpful than you might have thought.
Even inside traders struggle
A 2020 study by Chloe Xie from Stanford University analyzed the trading results of a cartel of inside traders who allegedly stole around 150,000 confidential press releases from the servers of three newswire companies and traded on the information they contained.
As inside information goes, it doesn’t get much better than that. But despite possessing such a reliable (albeit illicit) crystal ball, the investors had mixed success in identifying the stocks that would rise and fall in price the most.
Xie sorted all of the available press releases based on the actual stock returns resulting from the announcements; buying the 10% of stocks that rose the most in a given day, or selling the 10% that fell the most, would have produced the highest returns. But only around a third of the hackers’ trades were in those biggest winners and losers.
Eventually the US regulator, the SEC, intervened. Because they were based in Ukraine, most of the hackers remained beyond U.S. legal reach. But other people involved, including traders in the U.S., were arrested, charged, and given serious penalties.
Tomorrow’s front pages today
Now Victor Haghani and James White from asset management firm Elm Wealth have added to the literature with a new paper entitled When a Crystal Ball Isn’t Enough to Make You Rich. Haghani and White set out to test the assertion by economist and author Nassim Nicholas Taleb that “If you give an investor the next day’s news 24 hours in advance, he would go bust in less than a year.” So they ran an experiment involving 118 young adults trained in finance, which they called The Crystal Ball Trading Challenge.
The researchers gave each participant $50 and the opportunity to grow that stake by trading in the S&P 500 index and 30-year US Treasury bonds with the information on the front page of the Wall Street Journal one day in advance, but with stock and bond price data blacked out. The game covered 15 different high-volatility days, one day for each year from 2008 to 2022. Five of those days coincided with big employment reports, and five with Fed announcements, and the other five were picked at random.
So how did participants get on? Even with the advantage of having the next day’s WSJ in front of them, they fared badly. About half of them lost money, and one in six actually went bust. The average payout was just $51.62 — a gain of just 3.2% — which is statistically indistinguishable from breaking even.
Where did they go wrong then? Well, Haghani and White found there were two main reasons for their poor performance. First, participants struggled to predict the direction of stocks and bonds. Secondly, the trade-sizing decisions they made were poor; in other words, they weren’t very good at choosing how much capital to bet and when.
“By and large Taleb is right”
So was Taleb correct in his conjecture that investors given the day’s news in advance would go bust in less than a year? “While our experiment didn’t test his statement precisely,” the researchers wrote, “by and large we think Taleb is right. His counterintuitive proposition is both insightful and instructive.
“The financial industry is replete with individuals and organizations constantly working to develop their own proprietary crystal ball. (But) most stories involving people seeing into the future don’t have ‘happily ever after’ endings. There are usually unintended consequences that come with perfect prescience — a reminder that even prophets can’t escape risk and uncertainty.’
The Haghani and White study is another reminder of just how hard it is to beat the global financial markets. Predicting the future — whether that’s the outcome of wars or elections, the latest employment statistics or interest rate decisions — is extremely hard. Even if you call it right, you could still completely misjudge how the markets will react.
Nor is it just ordinary investors who fail to predict the future with any consistency. The so-called experts, such as fund managers, media commentators and academics, find it very hard as well. So basing your investment strategy on predictions, whether that’s yours or other people’s, is a recipe for disappointment.
By the way, if you’d like to take up the Crystal Ball Trading Challenge yourself, you can play the game here. Good luck — you’re going to need it.
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