Elements of noise and unpredictability
Now that we’ve looked a bit at the what, let’s get a high-altitude overview of the when. When we’re looking at a couple of stocks that we find interesting, as we said before we cannot just buy a stock at any time. I’ll discuss here why that is.
When we play chess, every move of a piece on the board causes a change of the setup, and opens up a set number of things that can happen. Everything needs to happen by very hard rules, and there are no exceptions. Every setup of the board will allow a given and finite number of things that can happen, but everything must happen according to the rules. Hence, there comes a strong element of predictability, and the better players are those that have the most experience, developed the strongest instinct, and can effortlessly predict what the other player will do according these hard rules. Such a strict rule set makes chess, to a large degree, a deterministic game – nothing can appear randomly, everything is part of a rule.
The stock market works a different way. Of course there are rules for how things work, and patterns that repeat reliably, otherwise there would be chaos. But rules here are rather soft, as for every rule and strategy that exists, there is always an element of randomness that can turn things either way, and an element of discretion. A system such as the stock market is thus, to a large degree, stochastic (i.e. determined by odds and probability).
Note that I said for both ‘to a large degree‘. We will revisit this at a later time, but for now let’s stick with the basic idea.
Markets are most certainly not random in their nature, as the infamous “random walk theory” would have us believe, which was invented and is still believed by a bunch of people who were unable to beat the market and sought justification for that. There are just too many skilled speculators to explain away with “luck”. No, markets are not random, but they have at times elements of noise, point event randomness and unpredictability in them.
That is because they are not a machine, a game with set rules such as chess, a global computer algorithm, a bank software or a price system fixed by bankers and governments, as many newlings believe. If you think back to what we learned before, markets are the composite sum of the psychology of all the people acting in them. In that respect, financial markets are just like real life. Literally anything can happen at any time, although the probability of something extreme happening is relatively low. But if you can imagine something, no matter how stupid, odds are there is someone somewhere on the globe just doing that very thing.
Anything can happen with any stock – if you’ve been in the market for some amount of time, you will start seeing things that you would not have thought possible, in stocks that you thought priceless or worthless, to the up- and to the down-side. Any given day, week or month, it is very unlikely to see extreme things happening, but we still have to prepare for them, and accept that there is a certain likelihood of something happening.
You won’t always be right
The world is full of humans, people that act irrationally, emotionally, impulsively, unpredictably and seemingly random at times for their own reasons – and the stock market links them all up to a central point of interaction where everybody can do as they please, based on their own conviction. The market is thus a stochastic system, in which individual and crowd psychology introduces an element of unpredictability and point events of randomness.
That means, that nothing in the stock market can be characterized as 0% or 100% likely, nothing is guaranteed to happen or not happen, no black and white. For anything that occurs, there’s always a chance that something unpredictable or random can affect its course.
Going on, If you translate that onto yourself, and how you act in the stock market, the bottom line is that there is always a chance that you’re wrong. Everything that we do in the market is done based on a judgement that we form first, which in turn is based on what we perceive to be the facts. But our judgment and perception can be wrong, first because of our own fallibility, and second because of the effect of random and unpredictable events in the marketplace that are out of our influence.
You might have the right idea (e.g. select the right stock) at the right time and make money. But you might also have the right idea at the wrong time and lose money. You also won’t know whether your idea is right until after you’ve acted on it, because being right in the market means making money, and you won’t know that you’ll make money until you are starting to make it in reality.
That means there are a lot of scenarios where you can be wrong, and your judgment may be false. This is crucial to understand, and it is the main reason why most people lose money in the markets consistently – because they insist on their opinion, believing that the market is deterministic and must act according to their expectations, opinion, and what they perceive to be the facts.
When we stick to a speculation strategy, we have to make room for being wrong. Doing so, we can shift the odds in our favor so that this unpredictability, randomn noise, and our own potential to be wrong will only have minimal effects on our success in the long run.
Because of that, If you take only one thing away from this whole course, it’s the following:
The way to success is to factor potential unpredictability into your strategy, i.e. the possibility that you can and will be wrong. That means, quite simply, cutting your losses when you’re wrong.
Please read on about what cutting your losses means in the next guide.