There is something that seems almost perverse in the notion that it is possible to make money on the financial markets without predicting future price movements, whether of an individual security or of the market as a whole.
The trading world prizes “high conviction” strategies, whether based on deep research of the “fundamentals” of an asset or on the careful study of previous price charts. Such strategies necessarily involve stock market prediction methods.
How could they not? It is difficult to imagine a trader taking a strong view without that view being based on a forecast of some kind. To the high conviction trader, entering the market without some sort of prediction would be as irrational as motoring from Chicago to New York while professing complete indifference as to whether to drive east or west.
In this world, the algorithm predicting stock prices is the financial equivalent of a satnav.
A scary prospect?
It is quite true that many traders would find the notion of managing without any kind of prediction scary, to say the least. And, as we shall see, some prediction-free strategies do involve a certain amount of analysis, which purists may regard as being dangerously close to forecasting.
It is a sobering thought that someone with no meteorological qualifications would have a better chance of predicting the next day’s weather in the UK (about 75% of the time, tomorrow is the same as today) than would a veteran trader trying to forecast tomorrow’s market movements.
Because we do not know what will happen tomorrow, we construct predictions based on the information we have now. In simple terms, a trader can spend the weekend poring over Friday night’s closing prices in order to plot the likely next movements when trading resumes on Monday.
Or they can spend the same 48 hours analysing last week’s earnings announcements and dividend figures in the hope of unearthing valuable information about the fundamentals of the securities in question.
The blame game
The problem, of course, is that all this information is old, by definition. In a sense, it is dead data. It tells you what happened in the past, and little else.
Intuitively, we know this, hence the tangle that conventional traders get into with moving averages. Accepting that, for example, Friday’s close gives you very limited information about a particular security, the whole week’s closing prices are added up and divided by five to give a clearer picture.
But this gives equal weight to the oldest and the most recent data, so a “weighted” moving average would give least weight to Monday’s close, a little more to Tuesday’s close, and so on.
A second argument against making market predictions is the self-reinforcing nature of forecasting. When a trade comes good, it is only human for the trader to credit it to their own brilliant predictions. When a trade goes wrong, it is, again, natural to blame external events.
Natural and wrong. This is known as the “primary attribution fallacy” and it pervades many aspects of life, whether trivial (one’s children won the school sports race fairly, but were cheated out of victory on the obstacle course) or serious (military victories for one’s own country are deserved, while defeats result from underhand enemy action).
So, our trader has seen the light and wishes to adopt a prediction-free strategy. What next?
The “purist” strategy involves no real analysis at all. In a simple example, the trader decides to buy a security. Before doing so, they imagine three scenarios, the only scenarios possible – the price goes up, the price flatlines or the price falls.
They then plan how they would react in each of in each of these cases.
Stay light on their feet
Every trader is different, with slightly different reactions. But a fairly standard strategy would be based on a trailing stop-loss order, that “stop” price rises when the security rises, ensuring much of the upside is captured when the price eventually heads downwards.
This assumes, of course, that the price will rise. Should it fall, the stop-loss order will take effect fairly quickly. And if it flatlines? That would be taken as proof of the premise behind the whole prediction-free strategy, which is that we cannot know what will happen next, thus there would be little point in selling a security that may be as likely to rise as to fall.
In any event, they would add, they remain light on their feet, ready to move if the real price defies the chart patterns.
None of this is likely to stem the flow of books and television programmes telling traders how to predict stock-market movements, and the behaviour of other markets. Nor the excitable coverage of the latest stock market prediction algorithm.
But perhaps the last word on market forecasting ought to go to the renowned Swiss-American speculator, the late Max Gunther. When confronted with experts claiming to know where the market is heading next, he advised traders to ask themselves one question about these pundits: “Are they rich?”