Predicting the market?

[Grandus]

Hey!

I was wondering how many people DON'T think we can predict movements in the market, be it in stocks, in interest rates, or whatever, given a reasonable amount of research and work.

I'm in my third and final year of a Maths/Finance Bachelor, heading for a MFE, and my classes start to make me think that for anything to happen in market finance you need to try and predict the future. If you don't think you can predict whether stocks will be a better investment than bonds, or that the market's gonna be bullish, then you have pretty much no decision to make, and it's kind of pointless.

I for one don't believe the market is the least bit predictable, which makes me wonder if there's a place for people like me in finance, and if so, how is it done?

 

[C S]

I for one don't believe the market is the least bit predictable, which makes me wonder if there's a place for people like me in finance, and if so, how is it done?

Then you're either incredibly stubborn or ignorant of the literature. Even Malkiel writes in a fairly recent survey ("The efficient market hypothesis and its critics"):

"By the start of the twenty-first century, the intellectual dominance of the efficient
market hypothesis had become far less universal. Many financial economists and
statisticians began to believe that stock prices are at least partially predictable. A new
breed of economists emphasized psychological and behavioral elements of stock-price
determination, and came to believe that future stock prices are somewhat predictable on
the basis of past stock price patterns as well as certain “fundamental” valuation metrics.
Moreover, many of these economists were even making the far more controversial claim
that these predictable patterns enable investors to earn excess risk-adjusted rates of
return."

This is from an old-school proponent of the Efficient Market Hypothesis. Malkiel is of the viewpoint that the market is far less predictable than claimed, but he admits he's swimming against the tide. Even Fama just claims the market is somewhat predictable but you cannot profit consistently off your predictions. Now does Malkiel go as far as you and claim the market isn't "the least bit predictable"?

Well, he concludes, "pricing irregularities and predictable patterns in stock returns can appear over time and even persist for short periods. Moreover, the market cannot be perfectly efficient or there would be no incentive for professionals to uncover the information that gets so quickly reflected in market prices, a point stressed by Grossman and Stiglitz (1980)." Again, let me emphasize, this is from someone that thinks the market is incredibly efficient. In fact, you'll notice in the survey paper that when he can't quite refute some research he'll say something like (as in one example):

"Again, even if some predictability exists, it may reflect time varying risk premiums and required rates of return for stock investors rather than an inefficiency. And it is far from clear that any of these results can be used to generate profitable trading strategies. "

Malkiel's survey is well-written and contains a very nice set of pointers into the literature. I'd suggest taking a look at them. That might convince you there is predictability to the markets, but is not going to bring you close to learning how to make money in the markets. For that, there is a ton of stuff written by practitioners, but good luck separating signal from noise.

 

[bigbadwolf]

I for one don't believe the market is the least bit predictable, which makes me wonder if there's a place for people like me in finance, and if so, how is it done?

I'm not saying your stance is devoid of merit but why would you want a place as a professional in finance if that is your outlook? The unspoken assumption of finance professionals is that there are underlying patterns.

 

[Grandus]

Then you're either incredibly stubborn or ignorant of the literature. Even Malkiel writes in a fairly recent survey ("The efficient market hypothesis and its critics"):

This is not so much about market efficiency as it is about human beings trying to predict the future (and always failing miserably at it). We're masters of hindsight though, and we will always claim that this event or that event could've been predicted so easily... after it has happened.

And funny thing: part of the reason I've started believing this is because of the literature... I've recently read Black Swan, by Nicholas Nassim Taleb. Its base premise is just how much we try to and fail at predicting the future and its impact on our lives and the market.

I guess my initial post was unclear.

 

[C S]

This is not so much about market efficiency as it is about human beings trying to predict the future (and always failing miserably at it). We're masters of hindsight though, and we will always claim that this event or that event could've been predicted so easily... after it has happened.

And funny thing: part of the reason I've started believing this is because of the literature... I've recently read Black Swan, by Nicholas Nassim Taleb. Its base premise is just how much we try to and fail at predicting the future and its impact on our lives and the market.

I guess my initial post was unclear.

I thought, as this is a quant forum, that you wanted a more scientific discussion about forecasting. I'd be happy to discuss any objections or counter-arguments you have to the econometric methodologies in the literature. I'm not as interested in discussing people's philosophical insights about how good we are at predicting.

Never managed to completely read Black Swan, but it strikes me more as literature than science. I wonder if Taleb would agree with your summary. He was, after all, a successful trader for many years. You have to have some forecasting ability to do so.

By the way, Taleb has written at least one paper on predicting more accurately, "On the Difference between Binary Prediction and True Exposure with Implications for Forecasting Tournaments and Decision Making Research". Here's a random quote I found in it: "First, binary predictions tend to work; we can learn to be pretty good at making them (at least on short timescales and with rapid accuracy feedback that teaches us how to distinguish signals from noise —all possible in forecasting tournaments as well as in electoral forecasting — see Silver, 2012)"

Doesn't seem like he's saying we're "miserably" bad at predicting, does it? In fact, the academic literature I pointed you toward strongly suggests directional movements (up or down) are much more easily predicted than price levels. Machine learning papers on stock market prediction also tend to stick with binary classification as it is more robust against noise.