Why you should be a passive and not an active investor Part I: markets are impossible to predict
Note: this post is focused on general public investors and on public markets
Why you should not try to beat the markets. Why you should not pay others to try to beat the markets. In short, why you should be a passive long term investor who invests through low cost passive products.
This is a post that in two arguments, explains to you why your base strategy for your personal investing should not be to beat the market year after year, or to pay others to beat the market for you:
1. Markets are probabilistic not deterministic systems, meaning they are inherently unpredictable
2. Very few professional fund managers have consistently beaten the market in their careers. And your ability to identify them, and invest in them, is close to 0
Therefore don’t be the single patsy — the patsy that thinks he/she can beat the market regularly
And definitely don’t be the double patsy — the patsy that pays another patsy who thinks he/she can beat the market.
1. Financial markets are probabilistic, not deterministic
There are many areas that are very complex, but nevertheless remain entirely deterministic. Deterministic, in this context, means that one can know all the possible states of the environment in question. One such example are the satellite communications antennas that fly on airplanes. Creating such an antenna requires a lot of expertise in radio frequency among other things. And these antennas must be robust to the extreme changes in temperature and altitude that an aircraft experiences. However, these changes in the aircraft environment are entirely known and predictable in advance, and this is the key here. It is therefore quite possible to create such robust products: as we all know since flying airplanes works quite well.
Financial markets — the investment world, doesn’t work that way at all. In investments, of course you create products too, investment products — these are funds that people can invest in. However, you do not know the conditions of the system in which these products will operate, because on markets, conditions vary unpredictably and infinitely, and this is the key point. This is why we call this type of environment a probabilistic environment. Because there will never be any certainty about the environment’s conditions and therefore the performance of products operating in this environment. To use our analogy from above, creating a financial product that makes money for investors with the same consistency as an airplane flies people, is like building a plane — but a plane in this case that can fly on all planets, all gravities, all visibility, all cosmic storms. Because in finance all the parameters of the system can and do change.
And this changes everything. In satellite communications for airplanes, we are used to high product reliability: we expect a product to perform as desired, 100% of the time. Any exception is a very rare tragedy that typically sees many years of investigations. However in investing we consider an investment product that can correctly predict the markets more than 50% right of the time (and therefore that is wrong almost half of the time), to be excellent — financial firms would pay billions if not trillions for such a guaranteed product. But this is not at all how financial products work. Indeed, one of the biggest challenges for scientists and engineers who start working in finance is to get used to this difference in environment: to move from a field where they are used to creating 100% reliable solutions, to a probabilistic environment, where a reliability of 50.1% is considered excellent. And many of these engineers and scientists never get used to this and sooner or later return to other fields as a result.
2. This brings us to what one might call the chaotic nature of financial markets. Chaos is a phenomenon that was discovered, independently, in several fields, by scientists working in complete isolation from each other: biologists, chemists, physicists, from the United States to the Soviet Union. It took them a very long time to realize that chaos is a generalized phenomenon and not specific to a certain field, and therefore to give it its own field of study.
What the science of chaos tells us is simple: any system created from non-linear inputs, even very simple ones, very quickly becomes a chaotic system. And in a chaotic system, it is difficult to predict both the direction and the magnitude of change. Now, do you know of any input that is more non-linear than the human mind? Since what other investors think is the most important factor determining the value of a stock in the short and medium term, we can see why the chaotic nature of their combined thinking influences our portfolio of stocks, and makes any short to medium term prediction extremely difficult.
Make no mistake, the second great discovery of the science of chaos is that there are always patterns in every chaotic system, and these patterns repeat themselves in similar ways but on different scales. Some predictability is therefore possible, even in the most chaotic systems that man or nature can create. But in general, the larger the scale / timeframe of your predictions and the less predictive power you can have. At this level, we can compare financial markets to the global weather. After decades of research, we can predict fairly well whether the weather will be good tomorrow or not. And extremely complex trading systems are able to predict fairly well (again quite well in finance means 50.1% for example) over a horizon of a few hours. But just as no meteorologist has any idea what the weather will be like a year from now above your house, no economist or investor in my opinion has any idea what the European economy will do in a year, or what the Chinese central bank will decide in a year. The problem is this: While no meteorologist sells advice and recommendations regarding the weather in a year, thousands of fund managers and economists are charging huge fees and managing billions of dollars for investment systems based on their supposed ability to know what the world economy will do in a year.
In conclusion, I cannot repeat it enough. Many economists and professional investors are extremely intelligent, honest, and hardworking people (for the latter one myself included for large parts of my career). But their professional fields simply do not lend themselves to great predictive power. Point. I find a lot of accusations they face to be extremely unfair. However, where they are guilty and charged is when they claim to have greater predictive power than they really have. Which they often do, explicitly or implicitly, with unsuspecting audiences.
What did we learn here? There are deterministic fields, like airplane manufacturing or car engines. There, we pay experts (Airbus, Boeing, Mercedes, Tesla) to deliver us great products that are expected to work 100% of the time. When they don’t — an airplane issue, a Tesla autopilot accident — it becomes global news. Financial markets however are a probabilistic field, not a deterministic one. They are inherently unpredictable, and therefore you should not pay others to predict the markets for you, because just like you cannot, they also cannot. Aim to be a long term investor, a passive investor, and do not try to predict nor time the markets. In short, don’t be the patsy that pays another patsy to try to beat the markets for you.
