Why You Have No Clue What the Market Is Doing

Three decades ago, investor Dean Williams began a speech with an analogy between physics and investing.

For centuries, Williams said, physics was dominated by Newtonian physics, or classical physics, which taught us that the world moved in predictable ways that were measurable and precise. Give me a ball and a ramp, and I'll tell you how far that ball will roll. All you have to do is measure something now, and it will tell you what will happen next.

But then a new type of physics came around -- quantum physics. It told us that parts of the physical world were more messy and imprecise than we once thought possible. Measuring something now might not tell us what will happen next, because we don't really know what we're measuring, or if merely looking at something is causing the event we're trying to measure.

"What I have to tell you tonight," Williams said, "is that the investment world is a lot more like quantum physics than it is like Newtonian physics. There is just too much evidence that our knowledge of what governs financial and economic events isn't nearly what we thought it would be."

That was brilliant insight 30 years ago, and it still is today. It's brilliant because it's obviously right, but so few investors have caught on to it. 

Take an annual survey by Franklin Templeton Investments. Near the start of each year, it asks 1,000 investors whether the S&P 500 (SNPINDEX: ^GSPC  ) went up or down in the previous year.

Now, we live in the age of CNBC and Yahoo! Finance and iPhone apps, where no one lacks the data to know a simple statistic like whether the market went up or down.

Yet year after year, the survey shows that swarms of investors are utterly clueless:

  • In 2010, 66% of investors said the S&P 500 fell in 2009. Yet it was actually up 26.5%.
  • In 2011, about half of investors said the market fell in 2010. Yet it was actually up 15%.
  • In 2012, 53% of investors said the market fell in 2011. Yet it was up 2%.
  • Just recently, 31% of investors said the market fell last year. Yet it was up 16%.

I've seen a few explanations trying to reconcile this gap. One is that the discrepancy between perception and reality is a good thing, because it shows investors aren't swept up by short-term market noise.

But I think there's a simpler explanation. As Williams might say, investors think that markets are much more like Newtonian physics than they really are.

If you think of markets like Newtonian physics, your thought process probably went like this:

I remember 2009. The economy was losing 700,000 jobs a month. GM went bankrupt. Wall Street neared collapse. Economists made comparisons to the Great Depression. We had an $800 billion stimulus package that didn't do much. The government ran a $1.4 trillion deficit.

Of course the stock market fell. How could it not have?

Same thing for 2011. Do you remember 2011? Greece nearly collapsed. Congress nearly defaulted on the government's debt. The U.S government lost its triple-A credit rating. The phrase "double dip recession" was mentioned in the media more than 10,000 times, according to Google. Of course the stock market declined. How could it not have?

This way of thinking makes so much sense. You just measure what's happening now, and it will tell you what will happen next in ways that are rational and precise. Just like Newtonian physics.

But thinking about markets this way is totally wrong.

People looked around over the past few years and saw a collapsing economy, but from an investment standpoint what they were really looking at were collapsing expectations that set stocks up for a big rally. This isn't intuitive, so you only saw it that way if thought of investing in the chaotic lenses of something like quantum physics. The fact that most investors don't think that way explains why so many missed the rally over the past four years.

Williams quotes physicist Werner Heisenberg, who once said, "Can nature possibly be as absurd as it seemed to us in these atomic experiments?"

Investing and the economy lead us to the same question. We think it should be simple and clean and elegant, but it's really just an absurd slug of confusion and disorder. "One of the tricky things about the subject," wrote New York Times columnist David Leonhardt, "is that almost nothing is certain in the way that, say, two plus two equals four. Economics -- which is at root a study of human behavior -- tends to be messier."

The takeaway is not that there's a way of thinking that will provide you with all the answers. It's actually just the opposite -- that the best we can ever do is have a healthy appreciation for how chaotic and quantum-physics-like markets are. That means taking a simple approach to investing, not taking anyone's forecast or analysis too seriously, not following the herd, and giving yourself a lot of room for error. And perhaps checking to see what the market actually did, rather than assuming what it should have done. 

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 29, 2013, at 12:16 PM, ibuildthings wrote:

    It's hard to filter through all the noise, so a lot of people just don't try.

    To succeed in investing, you have to listen to and trust information from untrustworthy people:

    The investment industry succeeds by learning material information, then concealing it until they can profit from it. By then, they are selling it to you at a profit.

    Politicians succeed by winning arguments, not solving problems. It's what lawyers are trained and paid to do.

    The news media succeed by revealing the information deemed "OK to say" by their management and their managements' political connections.

  • Report this Comment On April 29, 2013, at 3:39 PM, hbofbyu wrote:

    What iduildthings said.

    However, I would add that the news media is more indirectly at fault than many realize.

    In the early 70's (about the time Walter Cronkite faded away), news no longer existed as a public service offered by the networks. It became about ratings and money.

    It has been downhill ever since as far as perspective and truth is concerned. The news media is not about what matters but about what sells.

    Financial collapse, disaster and ruin make money for the media. Relatively minor news stories are magnified greatly in order to create viewer interest. I think this adds to the misperception of what is really happening in the market and creates a misinformed public.

  • Report this Comment On April 29, 2013, at 5:58 PM, Chuck2010 wrote:

    The market movements driven by computers analyzing the "news" makes market data even more even less reliable. The recent fake story about the White House being bombed drove the market down until it didn't. The computer trading is only about siphoning off profits before someone else can. That tax proposal on trades looks better and better. A penny a share tax is nothing to most investors. The bankers, though, would notice and end the bad practice they are engaged in.

  • Report this Comment On April 29, 2013, at 8:39 PM, banmate7 wrote:

    Investing is about correlating certain metrics to a confidence factor in an outcome. For me, favorable value investing metrics are correlated to the greater odds of your investment giving superior returns. I basically am a <i>disciple</i> of Benjamin Graham & Warren Buffett in this regard.

    I use real metrics like the Graham #, EPS, BVPS, cash flow, and balance sheets. Again, I don't even imply determinism...merely some strong correlation...that has helped me to returns that beat market averages.

    Quite simply, value investing works in my frame of reference...a frame of reference defined by saving more than I spend, investing significant enough surplus, getting decent returns...and always provisioning for time.

    In other words...don't take a position if you don't have the time to patiently wait it out. For example, I had to hold 6 years, whereupon a JNJ investment in 2006 now has returned a 57% total return.

    In summary, I bought it at value...reinvested dividends...and waited...still will hold on until I retire.

    Best of luck all.

  • Report this Comment On April 30, 2013, at 5:01 AM, Mathman6577 wrote:

    Can't go wrong with owning a company like JNJ.

  • Report this Comment On April 30, 2013, at 11:29 AM, Darwood11 wrote:

    I agree with the comment about "filtering through the noise." Further, so much of the media is about getting people to watch, that the talking heads will say whatever is necessary to get people to watch and continue watching. Do you feel bad about the market and finances? Well, we'll tell you what you want to hear.

    Too many people think of investing as a short term phenomenon. Too many think of it as a way to get rich; but for each trade there is a buyer and a seller. Too many believe what they hear. I know, because I get into these circular discussions with family members all of the time. Some were day traders, some were gamblers. Most find it impossible to comprehend that my retirement portfolio has increased 250% since January 1, 2008. But I'm simply a saver who invests to avoid the long term ravages of inflation. it's neither entertainment nor a way to escape a day to day working existence.

  • Report this Comment On April 30, 2013, at 11:40 AM, banmate7 wrote:

    Darwood, I completely agree with you. A lot of people don't take time to learn that trading options is a zero sum game. You are betting against somebody with an opposite position.

    Investing however isn't a zero sum game. I too have a very long term outlook. I use the stock market to slowly but surely acquire wealth. It doesn't mean I can stop working. Actually, my returns make me want to work harder & have more money for investing...confirming the incentive nature of this.

    Lastly, I also agree about most media commentary being "noise". It is appalling what passes for journalism. Even a good number of Motley Fool articles rely on misleading or histrionic titles, which is disappointing.

    Don't get me wrong, as I get some good info from Motley Fool. But you indeed have to sift & be careful. Unfortunately, as in most things in life, you have to be adequately educated to protect yourself from the seller.

    I don't blame Motley Fool writers. Apparently most people prefer sensationalism. Most people ultimately act irrationally...ironically giving investors like us opportunities to buy low & sell high.

  • Report this Comment On April 30, 2013, at 1:57 PM, jordanwi wrote:

    Morgan should head up a new site, a new arm of Motley Fool and Darwood/banmate7 should be first members. There's such a disconnect with what the average person thinks the stock market is for; most think that really smart people are finding diamond in the rough stocks and soaking up all the money. In reality, the smartest people I know buy the market and let it compound.

    Those trying to time AAPL, short BBRY, straddle XOM, buying LEAP options - do yourself a service and buy Vanguard products like clockwork, reinvest the dividends. Retire on a fat stack.

  • Report this Comment On April 30, 2013, at 3:31 PM, mikecart1 wrote:

    I'm almost 30 years old. I learned long ago asking something simple like who the President of the US is will get you multiple answers. There is only truth in life - the majority of people don't know it. The only thing you can control is yourself. Worrying about what others do is 100% time-wasting. So when it comes to asking these so-called investors what the market did any year is hopeless. Most of these so-called investors couldn't tell you why they own the stocks they own with any original thought.

  • Report this Comment On April 30, 2013, at 5:11 PM, toastedseeds wrote:

    It's astounding that so many people did not know that the market went up in the past year. Further astounding they call themselves investors. How is it possible to even pick an old fashioned newspaper once in a while and not see that the S&P is up? That speaks to a level of stupidity that is hard to fathom.

    ts

  • Report this Comment On April 30, 2013, at 6:26 PM, xetn wrote:

    I don't care what the S&P or the Dow does; I only care about how my individual investments do.

    From my standpoint, the levels of the S&P and Dow etc, are only gauges of how much money is flowing into (or out of) the markets. If you keep adding trillions of new dollars into the various markets, that tends to push up prices. Outflows tend to lower prices.

    As long as the Fed keeps creating new money out of thin air, a lot of that new money will flow into the markets and other investments such as real estate.

  • Report this Comment On April 30, 2013, at 9:07 PM, sciencedave wrote:

    Some have argued recently that we need to better educate our society financially (starting with school children). But then if we all understood perception is not reality and NEVER has been.....I would not do as well in the market. I gain from their mistakes.

    Same way I never complain about my co-workers inabilities or mistakes. They make me look that much better at the end of the year.

  • Report this Comment On April 30, 2013, at 9:57 PM, bamasaba wrote:

    A lot of folks also think that inflation is skyrocketing, go figure.

  • Report this Comment On April 30, 2013, at 10:13 PM, dbtheonly wrote:

    bamasaba,

    Remember there is an entire "News" network designed to promote a political philosophy. Selling the political spin is the goal. Not accurate information.

  • Report this Comment On May 01, 2013, at 2:29 PM, qazey wrote:

    People make things harder than they are. take the div aristocrats, contenders and challengers list. cross off every company you have no idea about. cross off every company that in 10 years you don't know how they will be making money. rank by pe and roic take best 3-5 companies. next year repeat.

  • Report this Comment On May 02, 2013, at 2:52 PM, banmate7 wrote:

    Sciencedave, the irrationality of the markets certainly creates opportunities for those of us who know how to value companies to buy low and sell high. However, I'm convinced we'd all be better served if markets were more normalized & smoothed, garnering even higher average higher returns, especially per investor.

    I think GDP would increase, not to mention generating cultural pressure on government to be fiscally sound. In aggregate, we'd all be wealthier, which I think is a good thing.

    As an aside, you and others here have made insightful observations and comments. It's actually encouraging. I'm also astounded by what some people posit as financial facts, never mind their analysis.

    I hope this will change. I passionately believe cash flow, balance sheets, value investing, and such topics should be taught all 4 years in high school.

  • Report this Comment On May 06, 2013, at 4:41 AM, ibuildthings wrote:

    Only one "news" network? Maybe one you don't like. But they all have their spin, and stories left ignored, and stories exploited to death. That "one" you won't name is at least kind enough to let the "other" party be heard. not something the others on the other political side willingly do.

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