Why the Stock Market is Unpredictable

The value of a stock is, essentially, a function of the amount of dividends it can be expected to pay in the future. Therefore, at any given point in time, the current market price of a stock reflects the sum total of the investment community’s expectations about the company’s future dividends.

Therefore, if the market’s expectations for the company’s dividends turned out to be precisely true, the value of the stock should not change over time.

Of course, stock prices do change over time. In fact, they’re constantly changing. Why? Because people’s expectations for the underlying companies are in a permanent state of fluctuation. New information comes to light on a daily basis that either improves or worsens the outlook for the companies in which we’re investing.

In short–as we’ve learned all to poignantly over the last year–we’re not very good at guessing.

And on a larger scale…

The same difficulty exists with trying to predict the future profits of the entire economy. All day long everyday, there’s news being released that makes people either more or less confident in our economy. There’s a functionally infinite amount of information involved, far more than anybody–or even any computer program–could keep track of.

What should we do about it?

First, accept the fact that the market is not predictable over short periods. Anybody trying to tell you otherwise is simply trying to make a buck off your gullibility. Ignore them.

Next, develop an investment plan that doesn’t require you to be able to predict the unpredictable:

• For short periods of time, use low-volatility investments like CDs and savings accounts.
• For long periods of time, use a mixture of bonds and higher-expected-return investments like stock-based, low-cost mutual funds. Then calmly/confidently accept the downturns when they occur. After all, such downturns are the price of the greater expected returns.