This guest post is written by J. William G. Chettle Chief Marketing Officer with our partner – Loring Ward. He discusses how using sports and other indicators (the length of women’s skirts) to predict future stock markets movements fails regularly. In discussing this failure, he even takes a shot at my beloved NY Mets.
As millions of people around the world watched Super Bowl XLVII last February, at least some were concerned more about how the outcome would affect their portfolios than the game itself. According to the Super Bowl Indicator (SBI) theory, the winning team indicates the fate of the stock market for the rest of the year.
The theory holds that if a team from the former American Football League (like the Baltimore Ravens) wins, the outlook for stocks is bearish. On the other hand, a win by an original National Football League team (like the San Francisco 49ers) indicates that the market will go up that year. The SBI has been remarkably accurate, correctly predicting the annual direction of the stock market about 75% of the time. If you believe the SBI theory, we should not expect a great 2013 for the stock market.
And if you follow financial news closely, you know that Wall Street is awash in theories on the performance of the stock market and the economy. Most of them sound plausible enough, based on expert analysis of data or superior research. There are also a number of downright bizarre theories. For example, if the NY Mets reach the World Series (only 4 times in the last 5 decades in 1969, 1973, 1986 and 2000), the market is supposed to experience a serious decline. Adherents of this theory can only hope the team doesn’t do well this year.
It is also supposed to be a bad sign for investors if a horse wins racing’s famed Triple Crown. This has happened only 10 times in almost 100 years, and not since 1978. There was no Triple Crown winner in 2013, but don’t despair completely if there is one next year. The market enjoyed positive returns 8 out of 10 times the year following a Triple Crown victory, returning an average of 8.9%.
Whether it is horseracing or football or baseball, the central problem with all these theories is a confusion of correlation with causation. Just because two variables move together does not mean that one is influencing the other. If you mine data deeply enough, it is easy to find completely disparate variables that seem to react in similar directions.
This is sometimes known as the Texas sharpshooter fallacy, a logical fallacy in which unrelated data is interpreted (or manipulated) to seem meaningful. The expression comes from the story about a Texan who fires his rifle several times at the side of a barn, then draws a bull’s eye around the hits and proclaims himself a sharpshooter.
A classic example of the Texas sharpshooter fallacy is the belief that if the Washington Redskins lose their last home game prior to the election, the incumbent party will lose the White House. This theory has worked in 20 of the last 21 elections — it failed in 2012 when the Redskins lost their last home game but the incumbent party kept the White House. Rationally, we know that football and elections (or football and markets) have nothing in common. But theories like this have an almost seductive hold on us, in part because our brains are hard wired to take mental shortcuts. Often referred to as “heuristics,” these are largely rational rules, coded by evolution, which help us make decisions and solve problems.
These rules work fairly well under most circumstances, but in some cases they can lead us to make serious mistakes due to cognitive biases — or distortions in the way we perceive reality. For example, we tend to think that trends will continue. Applied to stock markets, this can lead investors to believe that a rising market will keep rising…and that is how booms become bubbles. Conversely, when markets are falling and the economy is in trouble, it is hard to believe that the stock market will ever go up again.
We also have a heuristic for spotting patterns, which is very helpful in drawing meaning out of the noise and confusion of life. But this can shade over into what psychologists call “the clustering illusion” or seeing patterns where actually none exist. Life is chaotic and uncertain, and investing is no different. You can flip a coin a thousand times and potentially get tails every time. That’s the problem with randomness — it can sometimes appear meaningful.
From football to horse races, we yearn for signs and directions that will make the markets seem just a little more orderly and predictable. Most of us are smart enough to shun the more obviously implausible theories…but many investors still believe in a theory of investing that has repeatedly proved unreliably uncertain but remains widely popular: active management.
As studies have shown, active investment management works only a small and inconsistent amount of the time.1 It has proven difficult, if not impossible, to predict which managers will under or outperform in the future. In fact, many of the far-fetched theories we’ve considered here don’t perform much worse (and sometimes even better) than professional money managers with decades of experience, large research teams and access to enormous amounts of research and data.
Markets may be chaotic and unpredictable over the short term, but in the long term they are remarkably efficient and almost impossible to beat. It is much more prudent to invest for the long term, allocate your portfolio prudently and stay the course.
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