The Motley Fool

Confessions of A Retail Investor, Part 3 : Why You Can’t Predict Stock Prices

Easy access to interactive stock investment tools is a dream-come-true for retail investors. With just a few taps, we not only get instant stock quotes, but also up-to-the-minute company data like P/E, P/B, and cap size, all on a neat dashboard.  And most potent of all, we can get our hands on interactive stock charts, complete with technical analysis tools like candlesticks, moving averages, RSI, etc.  This seemingly sophisticated setup easily leads us into thinking we know it all, and we can control it all.  We might actually believe we can really predict market movements and stock prices.

Sadly, we can’t.

Put that crystal ball away

Take SMA (Simple Moving Averages), for instance. It’s simply a stock’s running average price for the past 10, 20, or however-many days indicated.  Many retail investors prize this statistical indicator, whether they are well-versed on technical analysis or not.

By itself, SMA simply describes a trend.  But when investors use it to predict stock price movements, trouble arises.  Often, investors look at a stock’s SMA lines in different durations, and conclude something like, “Now that the 10-day line intersects the 50-day line, it’s a good time to buy, because it’s a definite uptrend….”

This has the reassuring sound of a scientifically derived conclusion.  But let’s look closer, and see how its reasoning breaks down.

The investor here, in effect, is trying to predict a stock’s future price movements by looking at its past performance.  That means they’ve made two inherent assumptions:

  1. Stock prices follow a statistical pattern.
  2. Past data can predict the future.

There’s no pattern to follow

The first assumption is false: Stock prices do not follow any set pattern.  Many factors determine how stocks move, including individual companies’ fundamentals, the macro environment, and sector and market dynamics. And these things aren’t exactly easy to predict.

Take market sentiment, which is basically how investors collectively perceive the prospects of the stock. We’ve learned from countless lessons in history that such sentiments can swing wildly, abruptly and often irrationally.  The macro environment is no more predictable than market sentiments.  Just look at Brexit.

With these unpredictable elements at play, stock prices are by definition unpredictable, and do not follow any set pattern.

The past is not the future

The second assumption is more tricky. We often assume that past data will predict the future. This holds true in matters of science, where we can prove causal relationships.  But since stocks, as we’ve just noted, don’t follow a pattern, past data is at best useful reference – not a predictor of the future.

Assume Company A has delivered impressive earnings growth every year for the last 10 years.  Does it mean that it will continue to do so in the next 10?  Not necessarily.  It depends on many ongoing factors, such as business environment, management competencies, product competitiveness, industry trends, the macro environment … just to name a few.  And these are hardly certain.  All these factors influence the future earnings of Company A.  Past data is only part of the story.

As a Fool, I stand by the wise words of legendary value investor Warren Buffet, who once said,  “The only value of stock forecasters is to make fortune-tellers look good.”

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