The stock market does not know its previous history, and its past sequence of returns isn't going to shed any light on what it's going to do in the immediate future.
Last time I shared with you one of the biggest lessons I learned when I took my annual trip to Vegas (Don’t Be Fooled By Randomness) — that we tend to see false patterns in investment returns and use that data to extrapolate future returns. More often than not, that gets you into trouble. But let’s take it a step further.
Just like the roulette ball, the stock market does not know its previous history. It certainly doesn’t know when you’ve invested your hard earned money in it. And its past sequence of returns isn’t going to shed any light on what it’s going to do in the immediate future.
A Random Walk Down Wall Street
Burton Malkiel, an economics professor at Princeton University and author of the classic book , calls this the “random walk.” It means that the future direction of the stock market can’t be predicted from its past history. As he puts it, “a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts.”
Malkiel conducted a simple experiment years ago, and I modified it here to illustrate this concept. Suppose you start off with $50 and you start flipping coins. If you flip heads, you win $5. If you flip tails, you lose $5. I went to an online random coin flipper and flipped a coin 100 times. Then I looked at a sequence of past returns for the Dow Jones Industrial Average. Here’s what I found:
If I didn’t tell you ahead of time which chart represents my coin flips and which one represents the stock market, I bet half of you would guess incorrectly. The random coin flips look pretty similar to stock market trends. When you hear the financial experts talk about what you should do next with your portfolio, stop and think whether you’re just flipping coins.
Financial advisers also play investment roulette with your money all the time. Here’s one example that happens at banks and brokerage firms. The adviser plugs you in to one of their managed model portfolios, perhaps consisting of about 40 to 50 exchange traded funds (these are like mutual funds that trade like stocks — more on this in a future column).
You could have a China fund, an India fund, a clean energy fund, and S&P 500 fund, and so on. If you look carefully at your monthly statements, the funds switch around about every month or every few months. So an Indonesia fund would replace the India fund, and a biotech fund would replace the clean energy fund, and so on.
Unlike in Vegas this game doesn’t just have black and red — it’s got dozens of shades in between. It’s more like Russian roulette with your portfolio.
But as Malkiel states financial advisers and “financial analysts in pin-striped suits do not like being compared to bare-assed apes.”
So if you look at stock market charts or any financial data on returns and you’re making decisions based upon these “trends,” stop and ask yourself if you’re really just betting on a coin flip.