Have you heard the story of the man who predicted the Great Stock Market Crash of 1929? Karl G. Karsten, the proprietor of Karsten Statistical Laboratory in New Haven, Connecticut, demonstrated mathematically that the stock market was overvalued by as much as 25 percent, early in 1929. But Karsten himself, it seems, was not 100% confident of his conclusions, even though his observations were subsequently borne out by events. In fact, a couple of years later, in 1931, he wrote a book titled Scientific Forecasting, in which he essentially poked holes in his own methods. Karsten’s book offered numerous warnings about placing too much dependence on statistical forecasting — including his own!
So, what might we learn from this? Are predictions always wrong? Should we give up on financial analysis and just throw darts at a stock chart? Or is there a principle of sound investing that depends less on using the past as a way to guess which way the market is headed in the future — or even trying to outguess the market at all?
We believe that there are, indeed dependable, evidence-based principles that investors can rely on to build successful long-term strategies. But these strategies have little to do with predicting the future direction of a particular stock, a particular sector, or even the equity markets as a whole.
The first is efficient market theory, or EMT. This theory holds that, in the aggregate, the financial markets possess all the available information on a given stock or even a given sector, and that information is efficiently transmitted into the pricing of the securities. One way of thinking about EMT is by visualizing the world financial markets as a huge brain, and each individual transaction taking place as a single brain cell. Individually, a single transaction carries relatively little information. But when considered in the aggregate — with millions of transactions occurring in any given minute — the overall effect is that the markets appropriate, evaluate, and reflect the available data almost instantaneously.
In other words, we discourage any strategy that depends on trying to “out-guess” or “time” the market. Empirical research demonstrates, time and again, that no one can do that successfully on a consistent enough basis to generate above-average returns.
Another principle that we have found to be reliable is that of the dimensionality of the markets. Empirical research has shown that securities offering higher than expected returns in a given environment share certain characteristics, or dimensions. If those dimensions can be quantified scientifically and captured in a cost-effective manner, they can be used to construct a portfolio that can be expected to outperform over time. Rather than trying to tell our clients which stock is ripe for an upside breakout or when the next correction is coming, we focus our efforts on positioning them dimensionally, using good diversification, driven by an accurate understanding of their needs, risk tolerance, and objectives. Here again, rather than trying to pick the “right” stock or sector, we are positioning our clients to benefit, over the long haul, from proven characteristics of various market segments, allowing them to profit from letting the market do what it does best: pricing investments based on all the available data.
So, the next time you hear one of the media pundits making noise about the “coming crash” or the “huge upside breakout” that you can’t afford to ignore, remember Karl G. Karsten, the careful statistician from Connecticut, who had the rare good sense to maintain a healthy skepticism, even for his own conclusions.
If you would like to learn more about how we work with clients to build long-term strategies that work with, rather than against, the basic principles of the financial markets, please get in touch with us for a no-obligation appointment. To learn more about our investment philosophy, you can also read our recent article, “Diversification: Your Best Friend for the Long Haul”.