The Market Prediction Game: Here We Go Again...

There's been a lot of activity in the markets so far in 2008. We've seen uncommon (though harldly unseen) volatility. And with volatility comes one of "The Street's" favorite pastimes; The Market Prediction Game.

But how do these predictions tend to pan out? With talking heads doing their talking thing everyday, it's hard to keep track of the daily (hourly?) deluge of prognostications.

But when we do collect the information, it is telling. The Wall Street Journal surveyed top economists semi-annually, to get forecasts on what bonds were going to do over the next 6 months. The data go back to 1982.

The experts (intelligent people all, to be sure), were wrong in the predictions of the direction bond yields 66% of the time. That is to say, when asked 6 months from now will the yield on a 10 Year Treasury be A) Higher or B) Lower... they got it right 1 out of 3 times. (Source: Davis Advisors)

Do you realize how bad that is?

Employing a black-tailed marmoset to throw darts at a board marked "higher" and "lower" would be a better predictor!

MARKETPSYCH LEGAL COUNSEL DISCLAIMER: Marketpsych.com does NOT promote or otherwise endorse the practice of marmoset dart throwing. Sure, it's fun. But that's beside the point. Arming small, wiry primates with sharp objects for throwing is dangerous and most likely illegal in the US (with the possible exception of licensed establishments in the state of Nevada). Marketpsych partners are NOT responsible for damages suffered by those engaging in this activity.

The fact is, human beings are notoriously lousy predictors of future market events. A study by George Wolford and associates at Dartmouth College found that even rats and pigeons outpeform humans in short-term market prediction. (No word on marmosets).

This does not mean the market doesn't have cycles, or that patterns don't emerge. Indeed, to be wrong 2 out of 3 times (as the economists were on bond yields) lends credence to the notion that the predictions are NOT random. It points to the central theme of short-term reactivity that seems to dominate investing patterns - something we call Whack-A-Mole Syndrome. (TM)

My colleague, Dr. Richard Peterson, has written about it here in his superior book, and even developed the Marketpsych Fear Index which tracks how investor emotion is often an inverse predictor.

But the point is you don't need a crystal ball to be a succesful investor. You need a few simple but undervalued qualities. 1) The ability to recognize companies with proven records. 2) The ability to recognize when their stocks are at an attractive valuation vs. earnings. 3) The discipline to invest your money in them... and not monkey with it. (pardon the pun).

But we can't help ourselves. With so much information available, with so much money on the line, we love to engage in the Prediction Game. (By the way, Pats 34 - Giants 14 - you heard it here first!).

The Market Prediction Game reminds me of the end of the classic 80's flick, War Games (starring a young Matthew Broderick), when "Joshua", the American military super-computer aborts a nuclear launch on the Soviet Union because it realizes that it would result in mutually assured destruction. The computer learns the folly of the eponymous "War Game".

"Strange game. The only winning move is not to play."

Indeed, Joshua. So don't play.

How about buying some great companies cheap?

Or perhaps a nice game of chess, instead?

Market Fear: The Poison and The Antidote

If behavioral finance teaches us one thing, it is that Fear trumps Greed. In fact, it's not even close. Fear is like the Harlem Globetrotters playing the Washington Generals. Sure, ostensibly it's a real contest, but despite the ups and downs along the way, we always know who's going to win in the end. The outcome is predetermined, inexorable.

(Authors Note: I used to use the Yankees and the Red Sox for this analogy. But then David Ortiz hit that home run off Mariano Rivera in 2004 and rendered my metaphor obsolete. A pox on your house, Red Sox Nation!!!)

Fear drives the market. Why? Because losing hurts more than winning feels good. Because the future is uncertain, and the default emotion in cases of uncertainty is fear. Because you're not paranoid, the Market really is out to get you, and fear is the greatest weapon in the Market's arsenal.

How do we fight our fear? With "reason"? Well, some people do. And by "some people" I am chiefly referring to Vulcans - the supremely rational beings from the eponymous planet who are not afflicted by such human weaknesses as emotion. (Then again, Vulcans mate only once every seven years, so you can see why emotions could be a big drawback.)

No. For most of us on Planet Earth, we are forced to fight the battle on an emotional level. Reason definitely helps, but only so far as it helps us reacquire our emotional equilbrium.

Fear is a poison. But there is an antidote - Control. Not actual control (which is irrelevant) but the belief that that you have control. Fear beats Greed. Perception beats Reality - at least where our emotions are concerned.

We have seen this play out recently on marketwide level with the recent actions of the Fed Charmain, Ben Bernanke. The market flagged due to fear. (It always does due to fear.) But the fires of fear were stoked in large part because one of the main sources of investors' (sense of) control is the Federal Reserve Board.

After months of hearing "Inflation remains our primary concern", investors began to wonder if the esteemed Dr. Bernanke really "got it". The Market was saying; "Does he understand our concerns? Does he even care?"

Investors were riding shotgun with the Fed Chairman on a dangerous road. They were concerned there may be a cliff up ahead, but they were even more concerned that the Fed Chairman was asleep behind the wheel.

The first shot of control was injected back in July when Chairman Bernanke acknowledged that the mortgage crisis (and credit crunch) were on his radar screen. (Whew! He's not sleeping after all.) The second shot of control came when he lowered the discount rate. (He's awake and he's willing to hit the brakes.)

People called his decision to lower the discount rate a "largely symbolic move". Exactly. Symbols are important, especially when the symbolic gesture tells people, "Relax. I'm on it".

The Market has been calling (or is it whining?) for an interest rate cut. And I, for one, think that would be splendid. But investors got something even more important. They got back their sense of control.

It's like the immortal words of Mick Jagger:

"You can't always get what you want, but if you try sometimes, you might find you get what you need."

Bernanke's awake. It'll do for now.

MONEY-MONET!

I was on CNBC on Thursday, which I enjoyed immensely. (Clip here). They wanted a "shrink" to provide commentary of the current market psychology. We know people are jittery these days. How could they not be? But we also know that panic costs people money big time. So how do you get back to the proper perspective?

Well, start by checking out the picture above. What does it look like to you? If your answer is "not much", than you have something in common with the vast number of investors viewing the market's behavior the past couple of weeks.

The photo above is a painting by Claude Monet. Monet was the founder of a new style of painting, French Impressionism. The style is marked by, among other things, "open composition" and "visible brushstrokes". What that translates into (apparently) is "make a bunch of dots and the dots become a picture."

Here's the thing to remember: A portfolio is like a Monet. If you get too close to a Monet, all you see is a bunch of dots (a phenomenon comically illustrated in the movie Ferris Bueller's Day Off when he goes to the art museum). The same is true with our portfolios. When we get too close, we see nothing but a bunch of dots. It's data devoid of context. The picture makes no sense, and when it comes to our investments, that's scary.

The key to appreciating a Monet or a portfolio is viewing it from the right distance.

(Waterlillies)

This means resisting the constant pull to look at our investments from a weekly... daily... (minutely?) framework. If you look at a chart of the past month, it will provide a frighteningly volatile picture of big ups and bigger downs that may induce a feeling of motion sickness. If you look at a chart of the past 20 years, it is much more likely to produce what Glenn Frey would call a "peaceful, easy feeling". Volatility is not the same thing as risk, if you have the right time horizon. Perspective is everything.

I'm speaking of course not only about the distance of time, but of emotional distance as well. When we get "too close" emotionally to our portfolios the result is the same. This is one reason why working with a financial advisor (or failing that, an investing confidante) can be so valuable. Sometimes we need someone to tell us, "Take a step back".

Like Sisyfus rolling his stone up the hill in Hades or me organizing my desk, it is a neverending battle because, as humans, we are constantly, unconsciously and inexorably and being drawn into a short-term focus. (It's happening right now. Seriously. It is.) That's the side effect of paying attention to our world and we can't help it. But if we can make ourselves aware of it, and that gives us a fighting chance.

How do you keep yourself aware?: Reminders. Whatever works best for you. One option would be to get yourself a Monet print to hang in your office. They're cheap, they're easy to find, and they make a nice reminder of how we can't appreciate our portfolios if we don't have the proper distance.

Plus people at work will think you're "classy". Which is nice.