The Frontal Cortex

Market Analysis

There was a telling moment yesterday on the website. It was just after 10:30 in the morning and the top of the site featured a breaking news article about the S&P 500 heading into higher territory. The article offered the usual litany of explanations, from better than expected news on housing starts to a surprising uptick in retail sales. But here’s the catch: by the time I glanced at the article it was already obsolete, with the Dow and S&P down by a significant amount. A few hours later, a new article made its way to the top of the NYTimes site, explaining why the market was now in negative territory. (It had something to do with spiking oil prices and investors “waiting to see tangible evidence of economic recovery.”)

Similar stories appear on every single news site (and fill 12 hours of airtime on CNBC), as reporters and talking heads deftly try to explain the erratic movements of Wall Street. I think such explanations are especially popular in times of rampant uncertainty, which is where we are now. After all, if we understand the movement of the financial markets then we have a modicum of control – we know when to buy and sell – and people love control. In one classic 1975 study led by Ellen Langer, male undergrads at Yale were asked to predict the results of coin tosses, a cliched example of a random event. Nevertheless, a significant number of the men believed that their performance improved through practice – they got better at calling heads or tails – and that distraction would detract from their performance. How did they justify this wishful thinking? As Langer notes, the men engaged in some sly cognitive filtering and consistently “overremembered past successes”.

Is Wall Street any different? The market, after all, is a classic example of a “random walk,” since the past movement of any particular stock cannot be used to predict its future movement. Given this inherent stochasticity, it’s silly to attempt to explain the daily movement of the market: such an endeavor is like analyzing a series of flipped coins, or trying to explain the payout patterns of a slot machine. We can construct theories – and some of these theories might even sound intelligent – but they’re ultimately futile attempts to stave off the flux.

What’s even more disturbing is that such errant explanations might actually cost us money, since they lead, inevitably, to over-confidence. (Those Yale undergrads vastly overestimated their ability to predict coin flips.) We become so convinced that the logical-sounding explanations are true that we forget we’re dealing with a random, inherently unpredictable system. The end result is too much trading. Consider this experiment, which I describe in How We Decide:

In the late 1980′s, the psychologist Paul Andreassen conducted a simple experiment on MIT business students. (Those poor students at MIT’s Sloan School of Mangament are very popular research subjects. As one scientist joked to me, “They’re like the fruit fly of behavioral economics”.) First, Andreassen let the students select a portfolio of stock investments. Then he divided the students into two groups. The first group could only see the changes in the prices of their stocks. They had no idea why the share prices rose or fell, and had to make their trading decisions based on an extremely limited amount of data. In contrast, the second group was given access to a steady stream of financial information. They could watch financial news on television, read The Wall Street Journal and consult experts for the latest analysis of market trends.

So which group did better? To Andreassen’s surprise, the group with less information ended up earning more than twice as much money as the well-informed group. Being exposed to extra news was distracting, and the “high-information” students quickly became fixated on the latest rumors and insider gossip. (Herbert Simon said it best: “A wealth of information creates a poverty of attention.”) As a result, these students engaged in far more buying and selling than the “low-information” group. They were convinced that all their knowledge allowed them to anticipate the market. But they were wrong.


  1. #1 Roland Branconnier
    June 17, 2009

    Nicholas Taleb’s “Fooled by Randomness” is an excellent read concerning how financial gurus delude themselves into believing they are psychics. Nobody can predict the future. If the financial gurus could do that they would be picking lottery numbers not randomly walking down Wall Street. I once flipped 20 heads in row, but I wouldn’t bet on the 21st flip being a head! If you are going to predict, predict often because even a broken clock is right twice a day. You can also scam people into believing you ARE a financial genius. Here is an oversimplified example. You publish a newsletter predicting the price of gold. You have 100,000 subscribers. To 50,000 subscribers you say the price of gold will go up. To other 50,000 you say the price of gold will go down. Discounting the fact the price does not change, 50% of your subscribers will think you made a valid prediction. Then reiterate the process multiple times. After 3 iterations, 12,500 of your subscribers will concluded you are a genius because your predictions were right 3 times in a row. Please give me your money, thank you!

  2. #2 Jim
    June 17, 2009

    So, Jonah, I’m curious how you invest your money? Do you still have mutual funds, etc., knowing all along that someone who believes that they can predict the market are playing with your money? Or do you just put the money in index funds, or investment certificates to balance out the risk?
    And, yes, I know not to get my investing advice from someone who isn’t a professional, I’m just curious about your personal habits, given how often you write about the imperfection of those who’s job it is to invest.

  3. #3 Comrade PhysioProf
    June 17, 2009

    That kind of stuff drives me absolutely bonkers! How anyone could listen to a single word these dumbass “financial reporters” say on teevee without laughing uproariously is beyond me. When the market goes up, of course that is always a “good sign”. A day or so ago, when the market dropped substantially, one of these buffoons said, “That’s a good sign!” Do you think they even believe the nonsense they spew?

  4. #4 Sam K.
    June 17, 2009

    I think you are missing something rather important. What the efficient market hypothesis says is that all relevant information is priced in. This does *not* mean that events don’t affect the prices; quite the contrary is true. When people try to come up with explanations, they are not making predictions. Looking at it another way, if someone told me information the market didn’t yet know, e.g. earnings of a corporation ahead of the official earnings announcement, you could certainly make a lot of money; this is insider trading. Although I agree with you that many of the explanations the media comes up with are bogus and extremely difficult to test, it’s theoretically more sound (assuming you believe in the EMH) than trying to make predictions based on this information.

  5. #5 stockchartist
    June 17, 2009

    Don’t know how many actually read your post but, from my perspective, the example you site from “How We Decide” is a perfect argument for giving up fundamental analysis and becoming a technical analyst, especially a trend-trading stock chartist.

    While charts don’t predict the future, they do reveal in a concise visual way what the universe of traders are thinking through their buying and selling actions. And mass behavior is repetitive and predictable.

  6. #6 Todd
    June 17, 2009

    Comparing the market to coin flips is absurd and frankly lazy. To my sheer amazement you are looking for intelligent life in the form of a daily publication. Publications have long been known to be the last to the party. I cite “The Death of Equities” in August of 1979 from that bastion of late, and useless news, BusinessWeek. For more evidence turn on CNBC, FOX “Business” News or “Mad Money” and go look at what your “experts” are doing.

    As for the study of business school students, you should also be careful there. What metrics were they looking at? Did any of them have any real experience investing? Probably not. Have you ever met an MBA? They’re not ones to really swim against current for the most part. So the know-nothings made twice as much as the informed group. Was that statistically significant? Was it for one year? Comon! Furthermore, this study was conducted in the middle of a period where the market lost 50% of its value only to rally 30 plus percent in 1975. A large percent of professionals would have trouble with this volatility. Funny enough, it seems very similar to the period we just went through that has banks failing, mutual fund imploding and hedge funds getting pounded. I am willing to bet that almost every MBA in that sampled was crapping his pants due to the sheer scarcity of job offers. Would the “informed” never-invested-in-my-entire-life MBAs do well? No.

    But people continue to ask the wrong questions. Why look at all stocks or even markets? Why look at stocks when you can look at businesses? Why play the market which is certainly a tough way to go when you can employ statistically significant strategies? As for overconfidence I won’t debate that. That one is spot on. But just explain to me the existence of the super investors of Grossbaum and Doddsville? Tell me why Buffett is the luckiest man alive… What about Klarman and Greenblatt? The EMH is a piece of crap that should be kicked to the curb. Just because the average investor couldn’t hit the broad side of a barn doesn’t mean that it can’t be done. Check your facts next time.

  7. #7 orion
    June 18, 2009

    Who the hell cares what the NY Times says?

    The NY Times, aka NY Pravda, has failed to report accurately on the biggest news story in history – the coverup of 9.11 – proving that its content is all spin.

  8. #8 Chetan
    June 21, 2009

    Good post Jonah – you’re addressing the fundamental problem of economics/finance (and other fields with huge stochastic elements): these are largely narrative subjects pretending to be scientific (Hayek used to call this tendency for fake rigor and causality – Scientism, ).Unfortunately the incentive systems (for both commentators and participants)are skewed towards those who give the false impression of control and predictability.

  9. #9 Francisco
    July 7, 2009

    Ecofasa turns waste to biodiesel using bacteria

    A group of Spanish developers working for a company called Ecofasa just announced a new biofuel made up from trash. This isn’t a biodiesel made from used frying oil; instead, it’s made from general urban waste which is treated by bacteria. The result of that bacteria? Fatty acids that can be used to produce standard biodiesel. According to the company’s CEO, the process is fully biologic, competes with no feedstock and is really sustainable. However, the process doesn’t yield that much actual fuel: just one liter of biodiesel from 10 kg of trash. The project is now in a development phase, but Ecofasa said that a commercially viable model could be ready in three to four years.