March 7, 2017    4 minute read

Predicting the Unpredictable: The Basics of Forecasting Theory

Market Hypothesis    March 7, 2017    4 minute read

Predicting the Unpredictable: The Basics of Forecasting Theory

One of the most fundamental questions every trader asks themselves is how markets will move in the future. What makes the difference between a good investor and a bad investor is their ability to predict such trends. The resources and tools financial specialists can use in forecasting are often things that their colleagues could not have dreamt of a few decades ago – but do they really help them make better predictions, or is this information overload rather a disadvantage?

The availability of such resources along with the openness of the financial markets means that anyone can trade – but this creates too many unpredictable movements, some of which are based on inaccurate information and lack of investing skills and experience.

Are People as Good at Forecasting as They Think?

It is typically believed that, even though some fluctuations in the short run are just impossible to predict, in the long term, the markets are considered perfectly rational, since economic agents are able to take into consideration many more factors and have more time to make thoughtful decisions. This is referred to as the Efficient Markets Hypothesis.

It states that at a certain given time, prices reflect everything publically known and related to a particular financial instrument, which means a stock price will only move for two reasons: due to a particular event (such as a development in the news), or as part of random fluctuations around the ‘real share price’.

This argument supports the idea of ‘unpredictable markets’ and was first described by Burton Malkiel. On the other hand, critics claim that, despite this, many asset management firms have managed to generate stable returns over the years and that the very different successful strategies out there all have one thing in common.

This is where the self-prophecy phenomenon steps in. Many behavioural psychologists hypothesise that, in general, humans are not as good at predicting the unpredictable – i.e., predicting financial markets’ movements. Their explanation of how many still get long-range forecasting right is because, in some cases, the majority of market participants have a common belief about a certain trend, news, or company, so they place similar trades – creating momentum which is generated by nothing but their shared belief.

Human Behaviour and Rational Economic Theory

Rational Economic Theory states individuals make decisions according to the long-term benefits they get from those. Nothing could be further from the truth as far as investing is concerned, though. There have been multiple studies producing similar results (Barber et al. (2009), Odean and Barber (2000)): the vast majority of individual investors lose money.
Yet the growing popularity of trading and the rising number of retail traders cannot be overestimated. The trading industry is arguably booming at the moment, as new online trading platforms emerge by the day (primarily targeting retail investors by providing them with the tools to trade stocks, currencies, commodities, and futures).
One can argue that this trend would not arise in the first place unless there was a growing demand for these services from those retail investors. So is this a question of imperfect information, or overconfidence bias? This is another topic ripe for debate.
Justin Kruger and David Dunning described the overconfidence bias phenomenon very well in a recent study. This graph illustrates one of the conclusions they came up with, which could certainly support the idea of overconfidence being the reason why retail traders lose money.
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However, not all humans are bad at predicting the financial markets. There is at least one person in the world who does it with exceptional accuracy: he is the Tiger manager who managed to predict the movements of the Dow Jones index. This model uses the ‘Tiger Bears and Bulls Index’, which measures the performance of a leading gold player and compares it to a stock market index. This is just one of many so-called exotic indices.
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