How to Harness the Power of the Free Market
Investors who try to forecast, stock-pick, time the market, or employ track record investing usually end up with dismal return rates over the long term.
Why? Because financial markets are random and unpredictable.
It would be like trying to predict the future. For example, who could’ve predicted COVID-19 showing up out of nowhere and bringing the market down the way it has?
However, by understanding this unpredictability, you can actually harness the power of the financial markets to potentially create financial growth. There is power in knowledge and we believe in helping investors know exactly what they are doing with their money and why.
Investing for the long term with an academic-based investment strategy based on your true purpose for money will help you support your life with choices that inspire new possibilities, and build a future around what’s really important to you.
Once you’ve defined your true purpose for money--that which is more important to you than money itself, it’s helpful to understand the underlying dynamics that make markets random and unpredictable. After all, how can the markets be unpredictable AND seem orderly over long periods of time? How can we possibly derive order from a chaotic state?
To find logical answers to these questions, it’s necessary to take a step back and unravel the reasons why some financial advisors and investors mistakenly believe that markets are predictable.
Let’s break down this reasoning and reach a new understanding of the mindset you’ll need if you want to truly harness the power of the free markets.
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Deterministic Systems Are the Culprit
The flaws in human reasoning that lead investors to believe in predictable markets are embodied in the characteristics of deterministic systems. René Descartes, a 17th-Century French philosopher, and mathematician, developed the Theory of Deterministic Reality. In essence, it theorizes that by using science, we can develop equations to explain the laws of nature and predict future outcomes.
Deterministic systems are defined by the following characteristics:
1. They’re human-ordered or controlled.
Once we know the laws and equations, we can use them to manipulate and control the future for our own benefit. This idea holds true in many areas. Take bacteria, for example. By learning how they function, we can create antibiotics to treat illness and kill them. This process forms a basic foundation for much of modern medicine.
2. Their initial state can be measured.
Let’s say, for instance, you want to calculate the constant speed of a ball hitting the ground after being dropped from a height of 100 feet. To do so, you must know the shape of the ball, the humidity and temperature of the air, and so on. Without extremely accurate measurements of the current state, calculating the speed of the ball is impossible.
3. There is a linear progression of outcomes.
Outcomes follow a linear, smooth progression, and changes are incremental. For example, when children learn written language, they first learn individual alphabet letters. Then they learn how to form words from the letters, how to sound out the words, how to read phrases and finally how to read books. This is all in consecutive order.
4. They have predictable, foreseeable future results.
The laws that govern the system can be formulated. Given the human-ordered, controllable nature of deterministic systems, a current state that is measurable and outcomes that progress in a linear fashion, all of this gives rise to predictable, foreseeable results at any time in the future.
When you apply a deterministic mindset to investing, it implies that there are known laws and principles governing investing that you can manipulate or take advantage of to create additional wealth.
Many economists and financial analysts try to predict the future based on the idea that economic systems are largely deterministic. Driven by this conviction, they believe in the effectiveness of stock-picking, market-timing and track-record investing. But this is a mindset that distorts reality and can lead to bad decisions and destructive investing behavior.
Understanding Chaotic Systems in Economics and Finance
Systems that are non-deterministic are called chaotic systems. Chaos Theory postulates that self-ordered systems regulate themselves while staying within broad boundaries. Even with the magnitude of scientific advancement, there are still many systems or processes that are random and beyond a human’s ability to predict future outcomes. Particularly from an investing standpoint, we have to come to terms with the idea of randomness.
Chaotic systems are defined by these characteristics:
1. They are random and self-ordered.
Adam Smith developed the concept that prices should be left unhampered by a controlled central process. He believed that through the process of supply and demand, markets could be self-ordered and completely unpredictable. Throughout history, societies that embrace this idea – encouraging the free flow of ideas, new companies, and pricing – have created wealth at a far greater pace than countries that have tried deterministic, human-controlled systems to do so.
2. They have an immeasurable initial state.
Edward Lorenz, professor of Meteorology at M.I.T., studied the prediction of weather using a deterministic model. He discovered that small, immeasurable initial conditions create extremely unpredictable, chaotic outcomes. The so-called Butterfly Effect explains why it is impossible to forecast with certainty what will happen to the weather several weeks from now – or when it comes to investing, what will happen in the marketplace over the short term. There are unknown and immeasurable financial and economic factors (e.g., company profitability, consumer optimism/pessimism, unemployment rates, etc.) that make it impossible to accurately predict the markets using a deterministic model.
4. There is a nonlinear progression of outcomes.
The progression of outcomes in chaotic systems are intermittent, nonlinear and unpredictable. Think of the quantum leaps in technology brought about by innovators like Benjamin Franklin, Thomas Edison, Henry Ford, and Bill Gates. Even The Beatles and Elvis Presley had a dramatic impact on the evolution of “popular” music. Economics and investing are impacted similarly, with progress disturbed by elements like wars, recessions, advances in technology, etc. These quantum leaps forward or backward are impossible to forecast accurately, but they can create massive amounts of wealth for innovators, companies, and shareholders.
4. They have unimaginable future results.
Random and self-ordered systems that have immeasurable initial states and a nonlinear progression of outcomes lead to unpredictable and unimaginable future results. Ultimately, life itself is unpredictable. New technologies, work environments, diseases, businesses, areas of science, areas of defense, areas of war, weather – these factors (and many more) are all changing in ways that are far beyond our ability to accurately predict the future.
As human beings and investors, we must come to terms with the idea that unimaginable results are inevitable. The outcomes of a chaotic system are simply unpredictable, and if we try to squash that unpredictability, we could potentially destroy any additional wealth that results from it. The unpredictability is rewarded over the long term with a risk premium. Eliminate the risk, and you potentially eliminate the premium.
Embracing the Chaos for Investing Peace of Mind
To find an investing strategy that works within the chaotic system, it’s essential to harness (rather than fight) the forces that drive and characterize the market. You can do this by building a diversified portfolio using asset classes that move in dissimilar patterns. The risk premiums offered in this random, self-ordering, unpredictable market can be realized over time while controlling the volatility of your portfolio.
Take comfort in the fact that markets are self-ordered. No one has to intervene for markets to create wealth and value. No one has to predict what the economy is going to do. Markets create wealth without anyone manipulating or controlling them. Given that free markets have developed wealth over vast periods of time, they are dependable when allowed sufficient time for the chaotic nature of a market to create long-term wealth for the investor. This is the mindset you must adopt in order to harness the power of the free market.
To learn more about smart investing strategies that can bring about true peace of mind, download your free copy of the Investor Awareness Guide.
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About Greg Hammond, CFP®, CPA
Greg Hammond is the chief executive officer of Hammond Iles Wealth Advisors, and co-founder of Planned Giving Strategies®. Greg leads a team of professional financial advisors providing customized wealth management and investment solutions for high-net-worth individuals, families, companies, and charitable organizations across the U.S.