Weekly Message: Uncertainty and Illusions

Every now and again someone will ask me what I think about so and so market guru’s prediction that stocks are either going to the moon or sliding into the gutter. As I’ve reported the past couple of weeks, some legit personalities have been in the market-sliding-into-the-gutter camp. The beauty of the equity market lies in its unpredictability: It is the quintessential humbler of mortals whose egos convince them that their past investment successes indicate that they’ve some unique and/or uncanny predictive prowess.

Alex Krainer, in Mastering Uncertainty in Commodities Trading: Generating sustainable profits in forex, commodities and financial markets through trend following, tells the story of two Wall Street wizards who once lost their way:

…in early 1995, Jeffrey Vinik, the manager of Fidelity Magellan, then the world’s largest mutual fund, got trampled by the markets as the internet technology boom was about to take off. At the time, Vinik held over 40% of the fund’s assets in technology stocks, proclaiming that most of his investors "have invested in the fund for goals that are years away… I think their objectives are the same as mine, and that they believe, as I do, that a long-term approach is best." But only six months after he wrote this, Vinik dumped almost all of his technology shares, selling close to $ 19 billion worth in two frantic months. In retrospect, it’s clear that Vinik was right on the money with his large allocation to technology companies, but fearing that the already “overvalued” tech stocks were due for a large correction, he deprived his investors of the windfall from one of the most spectacular bull markets ever. At the other end of that same bull market, another star manager made a similar and equally unfortunate mistake. While working for George Soros in 1999, Stanley Druckenmiller accumulated a significant short position in internet stocks he believed to be stupidly overvalued. He was right, of course, but the Nasdaq's meteoric rise eventually made him blink, cover his shorts and join the bulls on the long side. Shortly thereafter, the dot-com bubble burst and 75% of the internet stocks Druckenmiller shorted eventually went to zero. The rest of them fell between 90% and 99%. Instead of making an absolute killing in 2000, Stanley Druckenmiller ended up with the biggest loss in his career.

Tim Richards, in Investing Psychology: The Effects of Behavioral Finance on Investment Choice and Bias, issues a timeless warning:

All too often, spurious patterns and superstitious thinking accidentally produce the right results and then get dressed up as good investment advice. Smart investors need to hone their critical faculties to detect these fake tools, in just the same way they need to be wary of people who claim to have a perfect investing strategy.  

And helps us understand how the stress of market uncertainty --- and the human need to control --- can trigger illusory thinking that acted upon would in all likelihood do great harm to our bottom lines:

Uncertain conditions are those that are most likely to cause us to generate the random connections between events that, to all intents and purposes, look like superstitions. The key to these superstitions is that they allow us to try and exert control over the uncontrollable: they turn the unknown unknowns we can't control into knowns that we can. As investors, this means we start thinking we can predict the future, when the truth is we haven't got a clue. What do you think happens when an investor starts making investment decisions on the basis of illusory patterns? Yep, they tend to lose a ton of money.

So, please, never ever, evereverever, get fooled into believing that the blokes who I featured in my August 4^th and August 9^th videos (below) can know what they would have us believe they know.

Now, those featured guessers just happen to be among the ones who have the market heading to the gutter. We must also apply the very same skepticism to those mavens who have it heading to the moon.

Have a great weekend!

Marty