Option Trading Blog

I am not a religious person, but some wisdom can be found in the bible. One of them is the concept that prophecy is for the fools. You see it almost everyday when it comes to investing: “War is unavoidable” someone says. “Oil prices will continue to rise” says another. History is full of managers (and for that manner policy makers) who took risks when the unexpected happened. But yet, all the clues to what was about to happen were looked backed in hindsight.

In his excellent book, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, Taleb talks about the concept of a black swan. Black swan is an unpredictable event that defies prediction.

The disturbing property of a black swan is that it’s unexpectedness creates the conditions for it to occur in the first place. That happens because of the simple fact that if you would expect such a catastrophic event as 9/11, you would do everything to avoid it. Even the old parable “expect the unexpected” won’t do any good. If you expect it, it is no longer unexpected.

Another disturbing element, is what is called the “hindsight bias”. This means that looking back, you rationalize every event that happened as likely to have occurred. On hindsight, it was obvious company A would collapse and you’d lose all your shares. Why you didn’t sell your stocks before? Maybe you’d attribute that to unfortunate luck or lack of skills or intelligence on your behalf or both. The problem is that we get a false sense of security in our ability to predict events.

If you’d look back in history, you’d notice that most of the greatest revolutions of mankind were not predicted. Who would have predicted the internet revolution? Who would have predicted 9/11? The “hindsight bias” mentioned before would lead you to believe those were logic steps in our progress.

Here is something that most people in the finance industry don’t talk about and you should know: Analysts, paid to give recommendations of whether a certain stock is a good buy or sell, have in a certain way predict the future. It’s always nice looking back at their predictions and analyzing their success rate (their prediction against what actually happened) to discover some disturbing facts.

What do you think is their actual success rate? 80% ? 70%? what is a good success rate anyway? I’d say if you are willing to accept analysts’ predictions, you’d expect to get more than 50%. After all 50% means that you could match their performance by tossing a coin and deciding upon that whether the market would rise or fall.

You’d be surprised to know that on average, the analyst has no better shot at predicting what would happen in the stock market more than you by flipping a coin. This is not something that happened only this year. It happened in the past and would probably continue to happen as people still struggle to be fooled by prophecy.