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Why we still can't predict stock prices

Oct 21, 2009

Long ago, human beings were bewildered by natural phenomena. Our body of knowledge had not reached the point where the complex world around us could be explained in a rigorous manner. People tried, but they came up with notions like the earth was a flat object and it was at the center of the universe. And such concepts were zealously defended. All that changed with the arrival of modern science through the efforts of such giants as Copernicus, Galileo, Newton and scores of other luminaries. After centuries of effort from the scientific community, we are today able to explain natural phenomena and in fact, harness it to our use. Of course, there are many unanswered questions for which science is still seeking an answer. But it is undeniable that very real progress has been made from the days of the flat earth society.

The human scale
While the brightest minds have focused on the physical sciences, some of them also went into the social sciences - economics, psychology etc. When it comes to these areas, we still do not have a set of tools that can compare with those from the physical sciences. One of the main reasons is that physical phenomena involve the microscopic scale - at the level of subatomic particles - and at the telescopic scale - at the level of galaxies and constellations. In contrast, the social sciences deal with phenomena at the human scale. As it turns out, the human scale is far more complex than the microscopic and the telescopic ones. In fact, the traditional tools of the physical sciences fare rather poorly when it comes to the human scale. For example, we can land a man on the moon, but we still don’t grasp weather patterns, water turbulence, and earthquakes very well. Recent developments in science such as chaos and complexity theory are an attempt to deal with these.

Investing and scientific tools
Investing attracts its fair share of bright thinkers. But the problem with investing is that it all happens at the human scale. So it shouldn’t come as a surprise that theories developed using the traditional tools of the physical sciences have not fared all that well.

The central question of investing is the movement of prices. Of the early pioneers in this area was Frenchman Louis Bachelier. At around 1900, he saw a similarity between the diffusion of heat through a substance and how a bond price moves. The dispersion of molecules in a liquid is also similar and is called 'Brownian motion'. All of them cannot be forecasted in advance. We can only calculate the probability of change in prices just like the probability of outcomes from the toss of an unbiased coin. In fact, Bachelier believed, if we plotted the price changes over time, it resembled the famous bell-curve or the normal curve from statistics.

Modern finance
Many years later the scene shifted to the US. Around the 1950's, Harry Markowitz applied Bachelier's ideas to develop the Modern Portfolio Theory (MPT). MPT describes the prospects of every stock through its mean (reward) and variance (risk). It describes how investments can be diversified to create an 'efficient portfolio'.

In the 1960's, William Sharpe took the concept of efficient portfolio ahead saying that if everybody held an efficient portfolio, then there would be one portfolio left, the 'market portfolio'. He then correlated every investment to this market portfolio to develop the Capital Asset Pricing Model (CAPM). The next step in the 1970's came when Fischer Black and Myron Scholes developed their model to value options. It was called the Black-Scholes formula.

The entire intellectual edifice is held by Eugene Fama who developed Bachelier's idea into the 'Efficient Market Hypothesis' (EMH). EMH basically says that in an ideal market, prices reflect all the available information and an investor cannot expect to beat the market.

Why we still can't predict prices
Unfortunately, empirical evidence is at odds with the theories of modern finance. They cannot explain why prices fluctuate as wildly as they do, why severe crashes occur, how someone like a Warren Buffett beats the market consistently for years etc.

Instead of brushing aside modern financial theory completely, let us examine some of their underlying assumptions which are flawed:

  1. Rational man: Modern financial theory assumes the 'economic man'. He is rational and always makes choices that maximize his utility. The truth is human beings are rarely rational. Most of the time, our behavior is driven by irrational biases. A field of study - behavioral economics - deals with the study of these irrationalities.

  2. Price changes are continuous: From the days of Bachelier, price changes are assumed to be continuous. That enables the use of neat mathematical tools. The truth is price movements are rarely smooth and are actually jumpy in nature.

  3. Brownian motion: Bachelier suggestion that prices move randomly like heat or water molecules and can be modeled like tosses of a coin is flawed because of two main reasons:
    • Independence: Today's price movements are assumed to be independent of the past. The truth is they are strongly correlated. The fact that a stock that has gone up 100% has a bearing on how investors bid future prices.
    • Normal distribution: Price changes are assumed to be mildly random and following the bell curve. The truth is prices can be wildly volatile which cannot be described by a normal distribution.

To conclude, our attempts at understanding price movements are still incomplete and flawed. As long as we do not come up with a price theory that passes through rigorous empirical tests, investors have to live with the fact the prices cannot be predicted.

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