I give many lectures on financial topics. In that context, I am frequently heard to say that economists know a great deal about the future. They can make solid estimates about “expected returns” and the long term performance of markets. To a great extent, good economists know what is going to happen.
Yet, with the same breath, I declare that the markets are rational and nobody can “beat” them after adjusting for random chance. It cannot be known in advance which stock or mutual fund will be the big winner next year. Indeed, I have even suggested that if the market is functioning properly, there are no bargains to be found
How can these two sets of ideas coexist? Can economic scientists really know so much about the future yet have no ability to beat the stock market? These statements seem to be directly in conflict. For years, I have searched for a way to teach these concepts. Is there some comparable situation from our ordinary lives that would make these ideas easy to grasp?
Consider, if you will, the weather. In particular, the amount of precipitation received by your home town. Can scientific experts accurately predict how much rain and snow you will get, or can they not?
I live near Philadelphia. Or region gets a little more than 40 inches of precipitation, on average, per year. Some years we get more and some years we get less. We’ve never had zero and we’ve never had a hundred. Indeed, in the past century and a half we have never had less than 25 inches nor more than sixty. It is fundamental to the scientific method that one measures past occurrences to aid in understanding the present and predicting the future.
Meteorologists can make a very solid estimate about how much precipitation will fall in the Philadelphia region over the next decade. They might even venture a pretty good ballpark figure for the coming year. If you ask a meteorologist how much rain or snow will fall on your next birthday, however, she will have no idea.
Can the analogous point be made about scientific understanding of financial markets? I propose that it can. Economists have a good idea, for example, of how the stock market will perform over the next twenty or thirty years. As for what the market will do on your birthday, or even the entirety of next year, however, even a Nobel Prize winner has no idea.