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.