Blog - Investing Notes

March 13, 2006 - Eight Simple Rules from Financial Market Research

There is no Law of Financial Market Gravity. As noted by Emanuel Derman: "In finance, more of a social than a natural science, there are few beautiful theories and virtually no compelling ones..." However, we offer here a few rules upon which one can depend:

#1. Broad financial market hypotheses explain what we have seen rather than predict what we will see. (See summaries regarding the Efficient Markets Hypothesis, the emergence of behavioral finance, the Adaptive Markets Hypothesis and the Entropic Markets Hypothesis.)

#2. The more sources you consult, the less likely you are to be wrong, or right. The average of all opinions is approximately no opinion. (See the bottom line in the summary table of Guru Grades and the average performance of trading systems at Collective2. As a crowd, stock market experts may lack independence, diversity and/or private knowledge.)

#3. If you track enough indicators, you can come to any conclusion you want. (Also known as the data-mining trap, this rule is a corollary of sorts to #2. Tim Wood is a good poster child for this rule, always finding in his charts reasons for caution or warnings of disaster ahead. See also the excerpts from Fooled by Randomness.)

#4. Short-term indicators offer returns that are small compared to variability. Noise swamps the signal. It takes a lot of trades, low transaction costs, careful trade sizing and nerves of steel to capture these returns. (For example, see the Super Bowl effect or the slinky effect or the VIX effect or how to price market news.)

#5. Some long-term indicators offer returns that are large compared to variability. It takes a patient lifetime with just a few trades to capture these returns, as a triumph of optimism. (For example, see summaries of research on valuation models and the Fed Model and long-term reversion of stock returns and earnings yield-interest rate spreads. See also our Reversion-to-Value Model and Real Earnings Yield Model.)

#6. Sentiment indicators lag the market. Most people invest in the past. (For example, see summaries of formal studies of analyst sentiment, investor sentiment and public sentiment, or our informal study of investor sentiment.)

#7. It will take 100 years to verify reliably the forecasting accuracy of your favorite apocalyptic oracle. (For example, just when will market valuations be favorable and when will the dollar lose all its value?)

#8. The [fill in the blank] effect tends to disappear when researchers announce its existence. (Consider again the Adaptive Markets Hypothesis, and see Chapter 9 in the summary of Triumph of the Optimists.)