Why is the stock market so difficult to predict?

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This is perhaps one of the most controversial questions that exist in the stock market. There are many people who believe that the stock market can be predicted, whereas, others believe that it is not possible.

Based on my experience, I would like to sit on the fence, because I believe that it is possible to predict certain aspects of it, but predicting the market with 100% accuracy is not yet a possibility. However, in the near future, we may reach a point where it could be the case.

I would like to point out two methods which have been used to predict the market so far:

Fundamental Analysis

This is an approach that aims to find the real value of a company, and in the process predict how much one share of a particular company should cost.

This approach is based on the assumption that with time the market will agree with the prediction and move in such a way that it automatically corrects itself. This method typically utilizes two metrics to predict:

1. Price to Earnings Ratio

The P/E ratio helps in the calculation as to how much an investor is willing to pay for every $1 of the company’s earnings. The predictive capabilities of the P/E ratio are based on the assumption that there is a relationship between the P/E ratio and high returns.

2. Price to Book Ratio

The metric which is most often used to predict the market is the Price to Book ratio. This ratio compares the actual value of the company to the value of the company mentioned on paper.

On the basis of this, predictions can be made based on the theory that if the ratio is high, then it means that the market has overvalued the company, and therefore lies the possibility of the price falling in the immediate future. Similarly, if the ratio is low, then one can expect the price to rise as the market may have undervalued the company.

Although both these metrics have some value regarding prediction it is not significant. Moreover, whatever predictions can be drawn from these, they are generally in the long-term.

Technical Analysis

Technical analysis uses the recurring trends and patterns in the price of a particular stock. This is a popular method on the internet.

Some of the reasons for its popularity could be the fact that it is intuitive and somewhat simple. Under this approach there are two major models which need to be discussed:

1. Moving Average Crossover Strategy

This approach depends on the interaction between two moving averages in different periods, one over a short period, the other over a long period.

When the short moving average crosses under the long average, it is taken to be a negative sign, and one can expect the market to go down.

On the other hand, if the short average crosses over the long average, it can be interpreted as a sign that the market is headed for an upward movement.

2. Head and Shoulders Pattern

According to me, it is probably one method that should be avoided. The main drawback of it is perhaps its methodology. Hence, I will not delve deeper into it.

Apart from these two, there are also other methods that fall under the technical analysis umbrella. These include Weighted Moving Avenger, Bollinger Bands, and Relative Strength Index.

Role of Machine Learning

Machine learning has brought about many changes in different sectors. Hence, we expect a lot out of it even in the stock market realm. However, when looked at purely from a prediction point of view Machine Learning’s contribution has been limited. So far it has looked to build models by exploiting relationships within the data itself.

Data could have been missed by the aforementioned methods. In the near future, better technology and more experience could mean that ML will play a bigger role in predicting the stock market.

Some of the reasons why it is also hard to predict stock market

  1. Stock markets go up and stock markets go down-

Why do stock markets go up and down? Because the market is a place where buyers and sellers converge. When there are more buyers than sellers, the price increases.

When there are more sellers than buyers, the price decreases. So what causes people to buy and sell? I believe it has more to do with emotion than logic. Because emotion is unpredictable, stock market movements will be unpredictable. It’s futile to try to predict where markets are going. They are designed to be unpredictable.

2. A waste of time-

Spending an hour trying to predict the future movement of the stock market is an hour wasted in your life. There are so many better things to do with your time. Now, don’t confuse this with knowledge. I think it’s good to read and learn but don’t think you can predict the markets.

3. Markets are more volatile than ever-

Mark Twain once said “October. This is one of the peculiarly dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August, and February.”

Markets are more volatile than ever simply because of more access to information and more resources to react to that information.

Technology allows us to buy and sell as many times as we want, whenever we want while sitting on the toilet from the comforts of our own home.

4. Perfection does not exist-

There is no such thing as perfection when it comes to investing. Many times, I’ve said that investing is not about perfection but rather about process and probability.

The key to success is to develop a process or a plan that attempts to increase your probability of being right more often than wrong (because you will be wrong sometimes) and enhances the probability of making money more often than losing money (because you will lose money from time to time).

5. Everything goes in cycles-

The stock market just like everything else runs on cycles. What goes up comes down and what goes down comes up. What goes up the most can come down the most and vice versa. After every bear comes a bull. After every bull comes a bear. After every correction comes recovery.

Unfortunately for all of us, the stock market is unpredictable and uncontrollable. That’s exactly why it can be so frustrating for so many people.

The market can also be a sea of opportunities to make money as long as you employ smart prudent investment strategies.

Don’t get caught up in thinking the stock market can be your secret way to get from rags to riches. That kind of speculation is about as risky as the casino or lottery and we know the odds of winning at that game.

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