Studying for the CFA exams changes your thinking in unexpected ways. I have noticed an inverse relationship whereas, the more I learn, the less I seem to think I know. This is not exactly what I expected when I began my journey into finance. Each topic in the CFA curriculum is a rabbit hole delving ever deeper into the underbelly of finance with each successive level. People know I follow the markets regularly and I have a voracious appetite for financial knowledge, I am often seen studying, watching videos or working out problems at my desk or in my HMMWV (highly mobile multi-wheeled vehicle or “HUMVEE”). It’s what I do. Therefore, it is common for people to ask me about what the market (or even individual stocks) may or may not do in the future. The stakes are high when their money is on the line and I am certain to disappoint because my reply is usually along the lines of, “I have no idea”. I can almost see what they are thinking, “You have a master’s degree and study this stuff all the time and you have no idea?”. JP Morgan has a famous quote along a similar vein where he stated, “it will fluctuate” after being asked what the markets will do. That is an even better answer than mine because they will indeed fluctuate.

I wasn’t always this way.  I read an article today which reminded me of my old self and how I used to think about markets. The article is entitled, “Why Stocks Won’t Earn You Nearly As Much Money Over the Next 7 Years” and it was written by Mark Hulbert (click on the orange words for the link to the article). The basic premise of the article is that the US stock market has performed above historical norms over the past 7 years and now it is time for the market to normalize over the next 7 years. I used to think similarly to this and it almost makes sense. Almost. I agree with part of the author’s proposition; markets are likely to return to their long-term mean. I just have no idea when this may happen and neither does Mark Hulbert.

When I started reading the article, my mind immediately recognized the author’s cognitive error. It is known as gambler’s fallacy. The easiest way to understand gambler’s fallacy is to think of a fair coin toss. The gambler (or analyst) sees that heads has come up twice in a row now and places a bet that tails come up next. If it doesn’t, the gambler is even more certain that the next flip will go his way, often increasing the amount bet. Tails must come up eventually, right? The truth is that each coin flip is an independent event. The fact that heads have come up 2 times or even 500 times in a row previously has no impact on the next coin toss. The coin has zero memory. The probability is still 50% that the next coin flip will result in heads. If you have ever seen roulette tables in casinos, you will no doubt have noticed the prominent display showcasing the last however-many results. This is an attempt to entice you to fall into the gambler’s fallacy and place a bet.

Perhaps you are thinking that the stock market is no coin flip. Unlike the coin, the markets (or, at least the market participants) have a memory. Okay, I won’t try to convince you otherwise for now because I am short on time and have studying to do. I will ask you this instead, why would the market revert to the mean over the next 7 years specifically? Is there something magical about the next seven year period? There is not as far as I can tell. Perhaps the author of the article knows all of this and picked a date 7 years out because nobody will remember what he said and by then it probably would not matter anyways.

Market analysts often fall prey to gambler’s fallacy when a pattern diverges and they expect it to reverse within a specific time period back to the long-term average. The author invokes Maynard Keynes and quotes, “Trees don’t grow to the sky”, to help prove his point. I can appeal to authority as well, Maynard Keynes also stated, “The market can stay irrational longer than you can stay solvent”. Both quotes are correct.

Is the market overpriced right now?

Probably.

When will the market normalize and revert to the mean?

I have no idea.

Stay in or out of the market at your own peril.