Before theory

I want to start this history with two papers nobody read when they were published. One is from 1900, the other from 1933. I like them because they are short, because they were written before anyone had a theory to defend, and because between them they say the two things I wish someone had told me at twenty-five: prices move in ways you cannot predict, and the people who get paid to predict them are no better at it than you are. Everything that came after, sixty years of theory, is an attempt to explain why those two things are true.

Bachelier, 1900

Louis Bachelier was a doctoral student in Paris who wanted to describe how prices on the bourse moved. What he wrote down was the mathematics of a particle being pushed around at random, five years before Einstein used the same mathematics for pollen in water, and he applied it to government bonds and options. His conclusion fits in one line: the expectation of the speculator is zero. The price already contains what buyers and sellers think, so the next move is as likely to go one way as the other.

His examiners graded the thesis “honorable,” which was a polite way of saying nobody cared. It sat in a drawer for fifty years until a few economists in Chicago and Boston dug it out and realized it was the foundation of everything they were trying to build.

Here is what I take from it in practice. Every trading idea you will ever be shown, from a bank, from a friend, from your own gut at two in the morning, starts with an expected return of zero. That does not mean the market has it right. It means that thousands of people with more information than you have already looked at the same thing, and the price is where they landed. The burden of proof is on whoever claims otherwise, and that includes you. I have learned to ask one question before anything else: what exactly is the reason this idea is not worth zero after costs? If the answer takes more than two sentences, it is usually zero.

Cowles, 1933

Alfred Cowles was a rich man who lost a lot of money in 1929 following the advice of professionals. Instead of getting angry he got organized. He funded a research institute and a journal, and he asked a question so simple it is a wonder nobody had asked it before: can stock market forecasters forecast?

He collected the recommendations of sixteen financial services, twenty-four publications and twenty insurance companies over four years, plus the famous Dow Theory editorials in the Wall Street Journal, and scored every one of them against the market. The forecasters as a group did worse than doing nothing. The best of them did no better than the best of thousands of portfolios picked at random. The Dow Theory, the most respected system of its day, lagged a simple buy-and-hold.

Cowles was careful about what he claimed, and I admire him for it. He did not say forecasting was impossible. He said that the forecasters who actually existed, when you measured them, showed no skill. Ninety years later that result has been repeated in every decade and every market where anyone has bothered to check, and I have never seen it fail.

The practical version is a small exercise I recommend to anyone who still reads bank outlooks. Every December the large banks publish their index targets for the year ahead. Collect ten years of them and score them against what actually happened. Then score them against the dumbest rule you can think of, last year’s price plus seven percent. Keep the sheet somewhere you can find it. You will not need to read another outlook.

Two habits

That is the whole chapter, and it leaves you with two habits, both old.

Treat price with respect. It is the summary of everyone else’s opinion, and it is usually better than yours.

Treat forecasts with suspicion, especially the confident ones, and especially your own. Skill is a claim, and claims can be measured. When they are measured, they usually fail.

The rest of this history is the sixty-year attempt to explain why these two things are true, and what an investor should do given that they are.

Gala, if you remember only one thing from this chapter: when someone tells you they know where the market is going, they are telling you something about themselves, not about the market.