By Jonathan Citrin
“Randomness” is a term not often associated with making money on Wall Street. Rather, images of Gordon Gekko or billionaire hedge fund managers come to mind. Some analysts reach deity status for predictions come true, youthful industry professionals aspire to match the predictive powers (and wealth) of Wall Street’s best, and individuals make their own forecasts based on something downloaded from the internet. We would never reward an investor’s admission of “not knowing.” We naturally prefer certainty and talent. We think we know what is important to successful investing—the ability to see through the noise and accurately forecast the future profitability of a company. Unfortunately, under the surface, this certainty and absolute confidence are the actual enemy of long-term investing success.
To become a better, more successful investor, you must understand and internalize one key concept, the ever-present irony of the markets, and the reason so many investors underperform—the markets are completely random and we humans cannot stand it. This satire couples our instinctive propensity for pattern-solving with the complete unpredictability of the markets. Simply, one of the most innate and human of abilities is the utter enemy of successful investing. And, only an acute awareness of and an investment process built to combat our inner need to solve the market’s puzzle will enable the success we all so desperately desire.
Within the markets, many economist and portfolio managers look toward history as a predictor of the future. Some read balance sheets and watch interest rates in an effort to make informed decisions.
We glorify those that “got it right”—throwing money at he who correctly predicted the downturn or accurately selected the market’s bottom. We reward anyone with the apparent ability to detect a pattern and lead us to the promised land of outperformance. The problem-markets are completely random, there is no way to predict. Further, this randomness not only exists, but also has been known for many years. Economist, scientists, and statisticians have documented the randomness of markets for more than 50 years. Countless research has proven this unpredictability time and again. So, why do we continue to look for the nonexistent patterns, to throw our money toward anyone whose crystal ball is, for the moment, seemingly more accurate than the next? The answer rests within our brain and the human subconscious.
The human brain is programmed to look for patterns. Our brain literally uses its emotional prowess, the result of many years of evolution, to decipher patterns in everything we contact. Humans are amazingly able to subconsciously determine patterns via feel and gut that our rational, conscious brain cannot. This ability is fundamental to what makes us human, what differentiates us from other species. It is truly vital and benefits us in many aspects of life, however, not when investing.
With recent developments in technology, neuroscientist abound are now able to see the human brain in action, to determine what makes us think we can outsmart the markets. Regrettably, the answer rests directly within the complexity of the markets. Our very developed, evolved brain is constantly tempted by volatility in much the same way we are drawn by the lure of gambling. The markets, just like a slot machine, pose an unanswerable question. Our minds chew on random volatility and instinctively spit out rationalized patterns and predictions for the future. The more random the data, the harder our minds work to find a solution-even when one does not actually exist. Neuroscientist Read Montague, through Jonah Lehrer’s work (How We Decide), notes, “People enjoy investing in the market and gambling in a casino for the same reason that they see Snoopy in the clouds… When the brain is exposed to anything random, like a slot machine or the shape of a cloud, it automatically imposes a pattern onto the noise. But that isn’t Snoopy, and you haven’t found the secret pattern in the stock market.”
The markets, like casinos, create a perfect storm of randomness. Match one of the most complex and random systems existent in the entire world with the natural pattern-finding drive of the human brain.
The result? Hundreds of millions of investors (professional and layman) trying to predict the unpredictable.
The bottom line is that those hoping to invest successfully on a consistent basis are not looking for patterns nor chasing hot analysts. Those that will experience success are investors who recognize the deceitful irony present in the markets. Simply, those who will achieve long-term outperformance understand randomness and the dire ramifications when it meets the overwhelming pattern-deciphering desires of our brain. Investors looking to consistently outperform can finally abort the guidance of professionals known for predicting or quickly reacting, now favoring portfolio management rooted in low correlated assets, investment policy statements, realistic expectations, and the control of volatility.
Armed with this knowledge, the right way to invest becomes clear. A decision to buy gold should not be based on one’s prediction of its growth prospect in the coming days. Instead, gold should be in your portfolio if you believe in its long-term value and it has a low correlation to other assets owned. The euro, on the other hand, should not be stricken from a line-up of potential holdings because you are nervous by recent rumors and headlines. The euro may instead play an important role in balancing your portfolio and mitigating export risks associated with dollar-denominated stocks already held.
By letting go of the notion that we can “figure it out,” investors can finally enjoy the fruits of long-term economic and portfolio growth. As Lehrer concludes, “Wall Street has always searched for the secret algorithm of financial success, but the secret is, there is no secret. The world is more random than we can imagine. That’s what our emotions can’t understand.” This awareness can significantly benefit your portfolio and your future. Have confidence in your investment process, not in the ability to predict.
Founded in 2003, Birmingham based CitrinGroup specializes in portfolio management and advises clients on investment planning and wealth management. For more information, visit http://www.citringroup.com.
