On October 12, 1981, The New Yorker published Robert Mankoff’s now-classic cartoon about the daily interpretation of financial markets. It cycles through four plausible explanations for a single day’s movements. Each explanation contradicts the one before it.
Nearly forty-five years later, Federal Reserve Chair Kevin Warsh boiled the problem down to six words:
“Interpreting markets is an imperfect business.”
Interpreting markets may be imperfect. Predicting them well enough to profit, and repeatedly changing a portfolio based on those predictions, is largely a fool’s errand.
That may be one of the most useful things a Fed chair can say, especially for investors.
Financial markets are extraordinarily complex systems. Prices reflect interest rates, earnings expectations, investor positioning, geopolitical events, tax policy, liquidity, sentiment, and countless other variables.
Perhaps more importantly, prices reflect what millions of market participants expected those variables to be before the news arrived.
A market can fall on good news because investors expected better news. It can rise on bad news because investors feared worse. It can rally after an interest-rate increase or decline after a rate cut. The same development described as bullish at 10 a.m. can be bearish by lunchtime.
Still, every afternoon, someone will confidently explain exactly why the market did what it did.
Explaining yesterday is relatively easy. Predicting tomorrow is something else entirely.
The problem is not that economic analysis is useless. Understanding inflation, interest rates, valuations and business conditions is important. It can help investors appreciate risk and form reasonable long-term expectations.
The problem begins when we make three increasingly ambitious assumptions:
We can correctly predict what will happen.
We can correctly predict how markets will react to it.
We can trade on that prediction at the right time, and know when to reverse the trade.
Each step is harder than the one before it.
Suppose an investor correctly predicts that the Federal Reserve will cut interest rates. That still does not tell the investor whether stocks will rise. Perhaps the cut was already reflected in prices. Perhaps investors expected a larger cut. Perhaps the cut signals that the economy is weaker than previously believed. Perhaps stocks initially rise, then fall after the press conference. Perhaps bonds rally while rate-sensitive stocks decline.
Being right about the event is not the same as being right about the market.
And even being right about the market once is not the same as having a repeatable investment process.
I spent years professionally immersed in markets. I saw intelligent, informed people reach sharply different conclusions from the same information. I also saw how easy it was to construct a persuasive explanation after prices had already moved.
That experience did not convince me that markets are always rational. They clearly are not.
It convinced me that identifying irrationality in real time, determining how long it will persist, and profiting from it consistently are very different things.
Markets do not have to be perfectly efficient or inefficient for market timing to be extraordinarily difficult.
Prices do not need to be correct at every moment or sometimes incorrect for this argument to hold. The point is that exploiting incorrect prices consistently is much harder than recognizing them retrospectively. Investors cannot eliminate uncertainty. They can decide whether their financial plan depends on overcoming it.
A prediction-dependent portfolio asks questions such as:
Will the Fed cut rates?
Is a recession coming?
Are stocks about to decline?
Is now the right time to move to cash?
Which country or sector will outperform next?
A planning-dependent portfolio asks different questions:
When will this money likely be needed?
How much short-term volatility can the plan withstand?
Which assets are appropriate for near-term liabilities?
Is the portfolio diversified enough to survive being wrong?
Can the investor remain invested through an unpleasant market?
The first approach tries to foresee the future.
The second prepares for several possible futures.
This is the thinking behind a strategy I call Asset Life Matching. Rather than trying to predict which asset will perform best next year, it begins with a more practical question: When will the money be needed? Assets can then be selected whose characteristics are appropriate for the timing and nature of those needs.
Forty-five years separate Mankoff’s cartoon from Warsh’s press conference, but the basic problem has not changed.
Markets move. Commentators explain them. Investors are tempted to convert those explanations into forecasts, and those forecasts into portfolio changes.
Occasionally, forecasts will be right. That is part of what makes market prediction so seductive. A correct call feels like evidence of skill, even when it may be little more than one favorable outcome in an uncertain system.
Luckily, successful investing does not require us to know what the market will do next. It requires us to recognize that we do not know, and to build accordingly.
We cannot control interest rates, economic growth, investor sentiment, or how markets will react to the next piece of news. We can control how soon our money will be needed, how much uncertainty our plans can withstand, and whether our portfolios are built for more than one possible future.
The goal is not to predict the future correctly.
It is to build a plan that does not require us to.