How random is the stock market?
Many say that they can predict the stock market. While others admit that they can’t and stick to a passively managed solution. (Hint: I’m one of the boring passive folks)
I can’t help it, I keep study how investments works. And no matter how much I study the most frequent answer is that a passively managed investment portfolio is the best solution for the mass.
The other day I learned that we can (kind of) predict the stock market.
There is a certain pattern that keeps showing up in the stock market.
Have you ever heard of the Francis Galton?
He was a super nerd borne in 1822. But he was a nice nerd!
Francis Galton was the man who build the foundation of statistics. Which we are going to talk about.
He invented a board, which later on ended up with the name The Galton Board. (I don’t think he came up with that original name him self)
He discovered that if we want to quantify almost everything. There is a certain trend, or a pattern. Which would look something like this:
This will later on be called “The Standard Deviation”.
That pattern will show up every time we want to measure something. If we want to quantify the average height of a person in this world the mean is likely going to be 1.70 m (Just a guess).
And far out on the left. There is likely to be 1 out of 10.000 which is going to have height of 1 m. And far out on the right, there will be a person who is also 1 out of 10.000. But that person has a height of 2.15 m.
Galton and The Stock Market
In this modern society, we are bombarded with information. There is so much information that we often don’t acknowledge how big of a privilege it is.
All of the statistics and research I can find on almost everything today. Is something that people in the 1920 could not even dream of.
The 4 % rule was is not something people knew about back in the days for example.
The cool thing about Galton’s finding. Is that we see the exact same pattern in the stock market. At ifa.com I have taken a 50 year period (600 months), and looked at the monthly return of a 100 % stock index portfolio. And this was the pattern that came up:
As we can see, it is the exact same pattern as Galton’s standard deviation.
Galton and My Portfolio
600 months, is a long period. So I thought it would be a fun experiment to see how my monthly returns would look like.
Will my monthly returns have the same bell curve?
After I read my first book called “A safe investment” I then bought my very first stock in August 2013. That book suggested that you bought 10-20 individual stocks, in different sectors and kept them forever.
Which I initially did. Later on I learned about how almost everyone is better served with index funds. So just before I graduated as a building constructor in November 2015, I sold all of my individual stocks and bought index funds instead.
From August 2013 to November 2015 I had individual Danish stocks, and from November 2015 til this date, I have had global diversified index funds.
From august 2013 to this day there have been 62 months. Only 1/10 of the 600 months I demonstrated from the IFA example.
But you know what ?!
My Galton curve ended up almost the same as the 600 month.
Which I was quiet stoked about.
As you probably can see. I have three months of +9% monthly returns, and I only had 2 months of -4 % or worse. If we believe in Galton’s theory there will be 3+ months of -9 %/month or worse ahead of me!
Yikes!
But what I do know that If I stay in a 100 % stock index portfolio, I will have approximately 1 %/month before costs on the long run.*
How To Predict the Stock Market With Galton
This means that we can predict the stock market. We know that the majority of monthly returns will end up in the middle. Which will be around -2 to +2 %.
But we also know that when we have a monthly period with is either a -20% or +20 % that it is most likely to be a 1 out of a 600 scenario. And according to the statistics is not going to happen again in our life time.
There will be periods where we will have more negative monthly returns (bear market) and there will be periods where we have more positive periods (bull markets).
But if we stay in the market, we know that this bell curve will show up.
So when a bear market shows up, just stay the course, and remind yourself that someday it will be more tilted to the right.