Imagine it’s 2020. Some genius political scientist in collaboration with a computer wizard has developed a flawless algorithm that can be marketed as a revolutionary predictor.
These geniuses offer their services to the United States President Donald Trump. In return for a generous down payment, they tell Mr. Trump that according to their forecasts, a revolution would certainly break out in the US during the following year.
How would Mr. Trump react?
Most likely, he would immediately lower taxes, distribute billions of dollars in handouts to the citizens – and beef up his secret police force, just in case the revolution breaks out.
These pre-emptive measures work! The year comes and goes and, surprise, there is no revolution.
Mr. Trump demands his money back. “Your algorithm is worthless!” he shouts at the scientist. “In the end, I could have built a few more mansions for myself instead of giving all that money to you for your dumb predictor.”
The scientist gets defensive and says, “But, Mr. President, the reason the revolution didn’t happen is because we predicted it.”
“A prophet who predicts things that don’t happen?” Mr. Trump remarks as he motions his guards to grab him. “I could have picked up a dozen of those for next to nothing from the Wall Street.”
Welcome to Chaos!
Remember the Hollywood blockbuster Jurassic Park?
In a scene, mathematician Dr. Ian Malcolm explains to Dr. Ellie Sattler why he thought it was unwise to have T-rexes and the likes romping around on an island.
John Hammond, the park owner, promises that nothing could go wrong and that all precautions were taken to ensure the safety of visitors.
Dr. Malcom does not agree. “Life finds a way,” he says. “History of evolution is that life escapes all barriers. Life breaks free. Life expands to new territories. Painfully, perhaps even dangerously. But life finds a way.”
Nature is highly complex, and the only prediction you can make is that she is unpredictable. The amazing unpredictability of nature is what Chaos Theory looks at.
Wait, we are not studying Chaos Theory today. But it’s important to remember that instead of being boring and translucent, nature is marvellous and mysterious. It’s its unpredictable and chaotic nature that makes nature marvellous.
Now, chaos comes in two shapes. Level one chaos, as Yuval Harari explains his book Sapiens, is chaos that does not react to predictions about it. An example is weather, which does not react to what the weathermen are predicting about it.
“Though it is influenced by myriad factors,” Harari writes, “we can build computer models that take more and more of them [myriad factors] into consideration, and produce better and better weather forecasts.”
Level two chaos, on the other hand, is chaos created by predictive models that break down because the very act of predicting them changes the course of events. This is exactly what happened in our story of the political scientist and Mr. Trump above, where the revolution did not happen because it was predicted.
Consider the stock market. It is level two chaotic system.
Imagine you develop an error-free computer program that forecasts with hundred percent accuracy the price of stocks tomorrow. You run it for, say, ICICI Bank (sorry, I suffer from recency bias). You forecast a price of Rs 325 for tomorrow, up from the current price of Rs 270.
What happens when a lot of stock traders know that yours’ is a super-accurate prediction? They all will rush in to buy ICICI Bank’s stock so that they can profit from the predicted price rise. As a result, the stock price will shoot up to Rs 325 today itself rather than tomorrow.
Then what will happen tomorrow? Some among the traders, like Mr. Trump in the story above, will curse you because your prediction of the price being Rs 325 “tomorrow” falls flat on its face. And why? Because you predicted it!
This is exactly what happens in the stock market prediction business. People predict for one year forward (sometimes based on ten years forward earnings), and because many others believe such a prediction in a rising market, the prediction comes true in three or six months. And then another, a higher prediction is made (the tail wags the dog).
So, it’s a self-fulfilling prophecy – a prediction that directly or indirectly causes itself to become true, by the very terms of the prophecy itself, due to positive feedback between belief and behaviour.
And that’s why it’s so important for investors to stop seeking or believing in predictions about the future of the stock market and stock prices, and instead study history. And why?
Here’s what Harari writes in Sapiens –
Unlike physics or chemistry, history is not a means for making accurate predictions. We study history not to know the future but to widen our horizons, to understand that our present situation is neither natural nor inevitable, and that we consequently have many more possibilities before us than we imagine.
History serves as a valuable tool and a great friend of the intelligent investor. You not only learn from the mistakes (like failed predictions) that others who came before you made, but if you dig just a bit deeper, you realize it’s a goldmine of ideas and insights that still work.
The players change, but the music never stops.
By the way, here’s a prediction I just came across and thought it may be music for your ears if you’re a shareholder in ICICI Bank –
By the way, are you really (and still) a shareholder in ICICI Bank? Chaos!
SEBI Registration Status: I, Vishal Khandelwal, am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578). But that does not mean, in any case, that I am intelligent and that you should trust me more than what you would do without this status. This is NOT an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. I do not own any stock mentioned in this post, but my analysis may be biased, and wrong. I have been wrong many times in the past.
P.S. The story at the start of this post is a modified version of what Harari wrote in Sapiens (Pg. 241).