One: 

Introduction

All investors face a host of dilemmas.  The primary one is between equities and bonds, but either of these choices cascades into dozens more.  Where should we get our guidance?  What can we reasonably expect to earn from equities?  The stock market is like no other market - we can watch it for years yet never understand its true nature.  Each generation gets fooled anew by its mysterious sticky luck.  I have started with some good ideas from other authors, but believe that a complete theory has not yet been written.  Some personal notes

Will we make more money investing in stocks?  Few questions can be more important to the average American today.   The demise of traditional pension plans has been accompanied by the staggering growth of individual retirement and brokerage accounts to replace them.  Even basic retirement education will show how compounded investment returns over a working lifetime make spectacular differences to the accumulated sums.  To achieve most peoples’ desired retirement security, a fairly uniform professional consensus has informed us of the need to hold a large portion of our savings in equity investment – stocks, as we commonly use the term – because ownership of the corporate world will provide the best returns over the long term.   History is shown to confirm this wisdom.  Even many market “bears” who warn of imminent crashes also hint at the fortunes to be made, post-crash, when stock bargains will be there for the taking.

Yet many investors are not fully convinced, and with good reason.  They have read of crashes and have probably experienced sickening slides in their own asset values more than once.  It is true that, at the time of writing, most have regained at least their original stake money, the exceptions mainly being concentrated hi-tech investment with unfortunate timing.  But they cannot dismiss the possibility – no matter how remote it may seem – of a 1930s-style market nightmare.   More likely, perhaps, would be a period of long stagnation, like the Dow’s painful journey from 1000 in 1966 to 1000 in 1982, with heart-stopping dips in between, and inflation a debilitating constant.  So our average investor stays partly in stock, partly in cash and bonds, and often nervously moves in and out of both when the market soars or shudders or dives.  Switching back and forth has proven to be costly, earning the investor an average return well below that of the market itself.

That soaring, shuddering and diving of the stock market… What is the investor to make of it?  When the market takes off we’re told, “The train has left the station.”  Do we jump on quickly?  When it dives we’re told, “Things are looking very uncertain.”  Do we bail before the real trouble starts?  Or has the take-off just made the market too expensive, and the dive just revealed some bargains?  Should we pay attention to historically high or low P/E ratios?  The Federal Reserve’s overnight rate is a frequent national news item for the masses, but how should we respond to changes in it?

There is much more besides to worry about.  How do we choose between market sectors?  Consumer durables versus high-tech?  Pharmaceuticals versus mining?  Transportation versus REITs?  How about small caps versus large caps, growth versus value, foreign versus domestic, emerging markets versus developed, ETFs versus mutual funds?   The range of choices is bewildering.  Some of us focus on a few “good bets” from reading articles and newsletters.  Some of us hand the job to a “professional” whom we believe must be well trained in making such decisions.  Some of us opt for broad indices which we hope will balance all this out.  Some of us pick the fund managers who have had the best track records in the last two, five or ten years.  It all seems rather hit-and-miss.  But if the past is any guide, we should do well anyway, right?  Equities should be better over the long term than dumping all our money into Treasuries, surely?

The Mountain Path Dilemma

Today, we stand high up on a mountain of equity growth and can look down on a long, steep climb, even though it included a few painful descents into inter-alpine valleys.  We may still not be much above the 2000 peak, but there’s no reason not to believe a much higher peak lies ahead, provided we stay resolutely on our path.  Then again, we simply can’t see ahead because of the thick mist which starts inches from our faces.  The next peak could be a very long way off indeed, and connected to here by a tortuous valley that could be so tough as to finally exhaust us.  Our guides laugh gently at us, pointing out how rare such valleys have been on the journey here.  But they, too, have not ventured any further than here.  No matter what patterns they have detected in the path so far, we are not reassured that such patterns can predict the untraveled path ahead.  

If we take the bond path across this terrain (that is, investing in quality, fixed-interest securities) we can be sure of a steady, unbroken, rising path.  But the slope is very gentle, requiring us to travel great distances for a small ascent – a path of steady gradient that constantly circles the equity mountain chain.  That path will take us a very long time to reach the heights we plan to reach.  Its gradual slope is barely detectable amid the frequent steep rises and falls of the equity path.  We can change paths any time.   If we do, we may soon find the equity path rise sharply above us or fall sharply below, making us either maddened or relieved.

All sensible investors realize that we cannot know the future, and are prepared to accept that they are taking certain risks.   But they want more information on two critical questions:

• What can I reasonably expect from the equity market?  In other words, if I accept the risks of the market, what is my expected reward for doing so?
• What strategy will get me to a level of risk with which I am comfortable, regardless of future events?

Much available advice on equity investment is either very vague on these questions or, in my opinion, fallacious.   The vague is, in fact, so vague as to be virtually useless.  For example, I have read respected advisors counsel their readers to “be very careful” in a “dangerous market.”  How exactly does someone implement such advice?  Clearly they are not being told to avoid the market.  Are they being told to invest very little?  Are they being told to switch to the bond path at the first sign of trouble?  It would not seem so; otherwise this is what the advice would actually consist of.  My cynical mind tells me that the advisor wants to avoid being proved wrong under any circumstances.  If the market falls, well, you were warned.  If it climbs steeply, well, maybe it just got more dangerous.  But just as the advice covers the advisor’s reputation, it is also not actionable.  Some advisors justify such words in terms of giving the reader the right “temperature” of the market.  But the temperature tells us nothing useful, either.  We need to know if it is steadily heating, cooling, or going to fluctuate wildly.  What, after all, is the “natural” temperature?

As already mentioned, one risk all investors want to know more about is the potential for a market crash.  The crash of which most of today’s investors have personal experience is the hi-tech debacle of 2002 which, common wisdom now tells us, was preceded by a hi-tech bubble that was just waiting to burst.  At the time of writing, many commentators believe we are experiencing the consequences of a housing bubble, in which many real-estate investors are being caught.  In Japan, the real-estate and stock-market declines throughout the 1990s have had such a profound effect upon thinking that even people without any investment portfolio or knowledge refer to the 1980s “bubble economy.”  To understand fundamental risk, therefore, we need to understand more about such bubbles and their aftermath.             

My goal is to connect together all observable behaviors of the stock market into one, well-constructed theory.  Why are there long periods of steady growth or apparent calm, followed by other periods of turbulence and sickening decline?  Why do bubbles – if they truly exist – form, and is their bursting inevitable?  Why does the market bob up and down gently for weeks, then for other weeks trend largely in the same direction?  Are there market patterns we can detect that will provide insight into future price movements?  Are there some “mega” underlying trends we can see if we can just find a way of subtracting all this day-to-day white noise?  Any complete theory of the stock market must provide valuable insight into these questions as well as telling us about expected rewards.  And, essentially, that theory must be actionable.  It must tell us something very concrete and relevant about how we should invest. 

Probability and the Time Value of Money

I do not present myself as someone with secrets that will make the reader rich.  It has always struck me that anyone claiming such credentials must anyway be a charlatan, for how can selling such a great secret at $10-$20 a time be more valuable than managing its exposure to maximize the value to one’s own portfolio?  I also do not fit into the category of a Peter Lynch or a Warren Buffett, whose words might be called “secrets of the superstars.”  As I explain later, I think such material is no more likely to improve your investment performance than a book by Tiger Woods would improve your golf, and there are good reasons to doubt any benefit.  My professional tools are probability theory and the time value of money.  Briefly, here’s why those two concepts are so important to the market.

The time value of money is the gentle, steady slope in our mountain-range analogy.  Though the equity market and bond market seem entirely different in nature, they are tightly linked in very important ways.  If the equity investor can always exit on a bond slope, and the bond investor can always enter the equity path, both investors are in effect making constant decisions about what they can expect from the equity path relative to the bond path, or vice versa.  If the bond path yields 5%, then the decision to switch paths will depend upon the investor’s view of whether equities will yield more, or less, than 5%.  The same kind of choice faces the corporate enterprise issuing equity or debt.  It will choose debt if it believes the return on marginal equity will exceed the price of that debt.  Both investor and enterprise will reflect any risk preference in their return calculations, of course.  But the fact that so many companies issue equity implies that they do not have full confidence their investment returns will always pay the cost of the equivalent debt.

To assess the risk of equities, we need to attach a probability measure to possible events.   I use games of chance to illustrate how markets can be essentially random, yet have characteristics that seem to suggest future direction.   I develop a probability model from this analysis, then use it to show how investors’ reactions to news gives rise to the patterns we see.  The games I use are driven by pure chance, and market prices are driven by expectations, yet the models turn out to be very similar.  My primary purpose is to prevent investors from drawing the wrong conclusions from what they observe.  Much about the market is not as it seems.  Robert Shiller, in his famous work, Irrational Exuberance, commented on the sharp gap between people’s familiarity with the market, which they hear about daily, and their understanding of how it works. 

We commonly mistake familiarity for understanding.  Imagine a child raised alongside a pet, baby tiger cub.  The child intimately observes every detail of the cub’s behavior over months and will project the cub’s gentle playfulness into the future, not understanding the beast’s intrinsic nature.  As we will see, the market’s playfulness can last for decades, convincing many that nurture has triumphed over nature.  Of course, we can’t prove that it hasn’t.  And market nature is hard to agree upon because, unlike millions of wild animals, we have only a handful of major stock markets and even these have largely converged.  But it is clear that not attempting to get to grips with underlying nature leaves us open to peril, like the child.

A Market in Deferred Consumption

Let examine the concept of a market.  The stock market bears no useful relationship to consumer markets, like fruit and vegetable markets, or flea or street markets.  In those markets, people’s immediate consumer needs and wants are matched with supply.   In an investment market, people want to maximize their wealth over time, and have deliberately deferred the joys of consumption.  They make choices between the various investment goods available, based upon their views about future investment returns.  We don’t have to assume that people make rational or irrational choices, a topic about which there is much debate.  But I think it a pretty safe assumption that an investor chooses item A over item B only because he or she believes A offers a better investment return.  If he or she does not, perhaps because B is a tobacco company, then this is an ethical choice, not an investment choice.  We are concerned here only with true investment choices, made to maximize wealth, no matter how bizarre or mistaken the reasoning behind that choice.

The actual return on a security will be determined by future events.  Market prices reflect investors’ expectations about these future events.  Changes in market prices reflect investors’ changing expectations.  Expectations change through new information.  Truly new information is a wholly random event, a fact which tends to support theories of market randomness.  Yet, in order to form their expectations, investors must use available information, and the only type available is historic information.  The only way to make any sense of historic information, when using it to judge the future, is to spot a pattern and attach a probability to its continuation.  So the market is a process by which random new information interacts with investors’ beliefs in their perceived patterns from history.  Almost nothing else in our daily lives – certainly nothing so important – is subject to this strange cocktail of influences.

Yet so much of the superficial trappings of the investment market look like other things which have dominated human life since our genetic code was first hard-wired.  It’s competitive, it’s exciting, it’s a constant see-saw of fear and greed; it is a potential fast-track to all the world’s goodies, to respect, to freedom from financial worry.  It is a constant puzzle which keeps us intrigued, yet which delivers patterns aplenty to uncover and to feel the joy of both discovery and the possession of a critical work tool.  There are leaders who can lead us, masses of data we can digest, dozens of theories we can consider, like-minded groups we can join.  We can celebrate when we win and commiserate – and be wiser – when we lose.  As with our ancestors, it’s the smell of red meat that gets us jogging along the trail after the wild herd.  It’s exactly the kind of activity that the human race is best at – brain-power plus adrenalin.  And all our other tool-making activity, such as the supercomputer and the internet, can be harnessed to refine our success.

These similarities to our ancestral know-how are illusory.  The true nature of the market is highly counter-intuitive, but we are often misled by our hard-wired animal instincts.  As intelligent animals, we have survived by using the past to predict the future, and this works excellently in such vital activities as pursuing wild herds and farming.  It doesn’t work with the stock market, as we will explore.  Yet the strange cocktail I described above – serpent might be a more vivid analogy – is perfectly designed to fool us into perpetually believing that we can learn to predict the market.  Paradoxically, this belief is what actually creates the market.  How else can investors make decisions than by projecting past patterns? 

Sticky Luck and its Origins

I use the term Sticky Luck to describe the market’s strange form of randomness that constantly has us seeing what we think are useful patterns.  When we think of randomness we think of things like random number sequences, or the types of games of chance we can indulge in at casinos.   But the stock market isn’t like that.  I will use a number of analogies and contrived games of chance to explain sticky luck, but my mind still goes back to one image that came to me early in this intellectual exploration.  Imagine a pair of large, hollow dice made of iron and partially filled with magnetic balls.  The balls tend to cling to one of the internal sides, making the gambler throw the same score – let’s say double sixes - many times in a row.  But, just as he convinces himself the dice are loaded to throw double sixes every time, the vigor of his shaking dislodges the balls which suddenly cling to another side.  Now he keeps throwing a different number.  Or the balls spread more evenly across the internal surfaces, and he no longer throws the same number each time.  The dice may now behave as if fair, or else roll the same number in groups of two or three, or just more often in one combination than any other.  He slaps the dice down hard in your hand and asks you to try.  You throw double sixes.  What are the chances of throwing another double six?  How sticky are those magnetic balls?

My hope is to assist investors in choosing an investment strategy that liberates them from chasing unrealistic goals, from losing money by responding to false “market signals,” and from paying excessive fees for imaginary services.  They should then be able to focus on the all-important activities of managing risk, minimizing expense loadings and optimizing tax efficiency.  In particular, once risk is managed, we are free to get on with the real business of daily living, cured from obsession with market indices and punters’ advice.

I would like to acknowledge three books that have motivated me to formulate my theory, though none did so in a direct fashion.  First, Shiller’s Irrational Exuberance described the abnormality of the late-1990s stock market and explained how a convergence and intensification of special factors during the prior two decades had led to an over-valuation by any reasonable historical measure.  Because publication coincided with the peak of the NASDAQ, some of the book’s fame followed from a presumption of predictive power, which Shiller did not claim.  He did not state that the bubble was about to burst.  Shiller’s concern centered round investors’ over-confidence in their expected returns and how – given the expensive levels stocks had reached – they could be proven very badly mistaken with dire personal outcomes.  The fact that the downswing occurred so quickly actually lessened the financial damage that Shiller had feared, though it was severe enough for some and uncomfortable for many.

Shiller is a leading thinker of the expanding school of behavioral finance, which examines how human psychology creates phenomena in market pricing which cannot be explained by other means.  There is no question that this school of thought makes a great contribution to our understanding of the market, and it is the cornerstone of Irrational Exuberance.  There is little question that many inexperienced investors got swept up in an “easy money” atmosphere in the period 1995-2000.  And yet, at the time of writing, we are back to a comparable position of stock-market optimism.  This time is different, we are told, because the prices are backed by great profitability.  Last time, it was simply the prospect of great future growth.  Yet profits can disappear just as quickly as growth prospects.  Neither argument trumps the other, unless you have just experienced the actual failure of one.  Both are rationalizations for the level of the market, and both were or are equally convincing to sensible-minded investors.  So to talk about “irrational” investment, without carefully defining the term, is likely to leave unexplored some important insights into market behavior. 

I make good use of behavioral explanations for investors’ actions.  Investors are often not acting in their own best interests.  They are, in my definition of the word, being rational, but they are applying rational thinking to an animal they do not full understand – in my above analogy, the growing tiger cub.  The great paradox is that all this rationality, based on applying human survival techniques to something that looks appropriate for their application but in fact is not, leads to the very efficiency of the market, as I will define it.  That efficient market still has unbounded volatility and hence great potential danger.  At the same time, that efficiency challenges anyone who expects to take advantage of others’ poor understanding and rationalization – at least, through open-market purchases, if not through selling questionable advice.  To assist investors, we need a market theory that combines the best of behavioral finance with the best of efficient-market theory, and this is what I have aimed at.  I will also explain why such an approach has not been made before.

Benoit Mandelbrot’s The (Mis)Behavior of Markets sheds critical light on market patterns with the use of fractal geometry (a math of which he is the originator).   The work essentially focuses on market prices as a mathematical sequence, rather than studying any behavioral causes.  His conclusions are that not only are markets much more potentially volatile than most people imagine, but also that there is no self-correcting mechanism.  Here, at a high point in the history of equities, it is easy to believe in the “inevitable bounce-back” theory – no matter how dark the night, investors who keep the faith will always see the dawn.  To date, this has been true in the United States.  It has not been true in Russia and China.  It was also arguably not true in Germany and Japan where property ownership was at the discretion of dictators and conquerors.  As Asia currently demonstrates that it can reproduce all American economic activity at a fraction of the price, and as the United States is viewed as the greatest threat to world peace by the majority of other peoples, why should our future success be so certain?  Images of invincibility are reminiscent of a globally dominant Great Britain in 1914 which, thirty years later, survived bankruptcy only through the common military goals of its primary ally.

James Surowiecki’s best-seller, The Wisdom of Crowds deserves mention for its explanation of why so-called experts cannot beat the crowd’s consensus.  Under the right circumstances, Surowiecki argues, wisdom is additive, as pooled yet independent perspectives can distinguish the voices of those who really know something useful and who will tend to reinforce the same knowledgeable vote, whereas those who do not know anything useful will tend to cancel each other out.  I personally believe that the circumstances under which this phenomenon works well are more limited that the author suggests.  However, there is an important truth that is applicable here.  When the market makes up its mind about certain prices, it is combining the reasoning of many individuals, both buying and selling.  In contrast, when predicting significant changes to those prices, professional advisors are predicting a major shift in the market’s reasoning, without the benefit of having any additional knowledge.  This might be plausible if the weight of invested money was in the hands of people who did not have their own strong views, or who were naïve and easily thrown by likely events.  But whether or not we agree with investors’ beliefs, these beliefs carry the sincerity of risk capital.  “Professional” predictions of changes in such beliefs, particularly when not accompanied by a massive injection of financial “sincerity,” are not convincing.  If they are accompanied by such massive injections, one then has to query the motives of the predictor.

Finally, in terms of books, I need to acknowledge Burton Malkiel’s A Random Walk Down Wall Street as the popular exposition (the 9^th edition claims one million copies sold) of efficient-market theory.  Though reading the book itself was not inspiration to this work, the roles of both Malkiel and Eugene Fama have been critical to the absorption over the years of the wisdom of the theory by individuals like myself. 

Fama is recognized as the father of efficient-market theory as understood today, and his academic papers are science of the highest order.  Despite such merit, however, he and Malkiel have been losing the popular debate on efficient-market theory to non-scientific arguments that appeal to commonsense notions of the stock market.  Such arguments often use as evidence other scientific studies.  I do not question the science behind most of the studies, but I believe many of the sweeping implications draw from isolated experiments are both invalid and harmful to our proper understanding of the market’s workings.   The broader public will not be influenced by the quality of the scientific discussion.  Moreover, as I will attempt to describe, the true nature of “market math” makes much of the science moot.  That Fama has been able to prove market efficiency over such limited periods of time is remarkable, but is not at all necessary to defend the concept of market efficiency.  What it has done is put some interesting boundaries around sticky luck, therefore telling us why we find so very few sticky-lucky investors in any Hall of Fame, as I will describe later.

Death of a Pension System

We are seeing the twilight years of pension plans, and the transfer of invest risk for retirement assets from company sponsors to employees.    Pension plans may be justly criticized as inequitable, lavishing secure incomes on time-servers and often treating miserably those employees who find the need to move on in order to realize their full potential.  Retirement savings plans avoid these shortcomings.  Yet we have now handed investment responsibility to employees as if there were “nothing to it.”

The growth of such savings plans has coincided, as Professor Shiller has pointed out, with the greatest bull market in history.  As a result, many small investors feel like they do not need much help in deciding upon quite heavy equity investment though, as I mentioned at the beginning, there is also widespread nervousness about a possible major setback.  It is here that employers and the fund management industry have been rather thin with help.  They talk about the averages of history, almost without reference to the fact that, for twice in the 20^th Century, many investors were ruined.  They talk about the importance of financial advisors and professional fund management, as if either had offered investors meaningful protection against market dangers in 1987 and 2002.  They provide no helpful commentary on the great noise of conflicting market and stock advice surrounding us, and often encourage savers to pick their own favorite commentator without any criteria to do it well.  And they offer little concrete advice for the most critical issues facing the equity investor:  risk, expense loadings and tax-effectiveness.

The focus on historical returns has encouraged investors to project real (i.e. over price inflation) returns of 6% or more, allowing them to conclude that 5% of pay accumulated in the stock market over a full career will provide enough to live on in retirement.  If real returns were 2%, the amount saved would need to be increased to 13% of pay to get the same balance at retirement.  It would need to increase to 18% of pay to get the same lifelong retirement income.  Of course, if our assumptions happen to prove too optimistic, we do not have the luxury of increasing our savings in past years.  I argue that a 2% real return is to be expected as least as much as a 6% real return and, if we are looking for market evidence, then the vote has to be on the side of the 2%.  But market evidence also does not preclude a much lower return.  And the balance of fortune does not work in our favor.  Though the return could also be much higher than the real 6%, that extra money will not be essential to our well-being in retirement.  The shortfall against the 2%, or even the 6%, may well be essential.

It would be very unwise for investors to assume that, if they fail to meet their targets, the government will somehow step in.  It would also be unwise for them to assume they can just continue working, at least with a good income.   The competition from abroad, whether through immigration or replacement of our own goods and services, is intense and will get more so.  Any visitor to Asia who studies both the business and social environment cannot be unimpressed by the levels of sophisticated, marketable skills that are coupled with a willingness to accept a much lower standard of living.  It looks unlikely that the full gap will be bridged simply through economic catch-up by the developing world, because the speed of workplace equalization is moving too fast.  Just as the world changed dramatically in the 1920s and 1940s to make the United States the leading economic power, so it is changing dramatically again.  Our first conclusion is that the history of the US stock market, which covered the emerging American ascendancy, cannot be taken as a guide for the future.  Nor can other countries’ markets, greatly untried in transparency, shareholders’ rights, political stability and monetary policy, be accepted as a ready substitute.  Our second conclusion is that Americans may be facing a substantial but limited window where they need to make a transition from a spending nation to a saving nation.  As less and less of the spending feeds our own economy, the need for this change will become more evident.

* * * * * *

In 1984, I was advising German companies on pension funding.  The German pension scene is unusual by international standards, with many employers investing pension money directly back in their own business.  One large industrial company was an exception, holding some $2 billion on deposit with an insurance company.  Its foreign parent was interested in my idea for moving the fund into equities.  Until that point, tax rules discouraged such investment but, with the assistance of a law firm, I had developed a new type of trust vehicle that seemed to remove the road-blocks.  (The vehicle did not become popular until about a decade later.)

Despite giving me polite audience to satisfy his corporate management, I sensed quickly that the German personnel director was not interested.  Finally, he spelled out his reasoning.  “Look at the performance of these equity funds,” he told me.  “One year they are ten percent down.  The next year they are fifteen percent up.  How do I know if my liabilities will remain covered?  Now, look at my current contract.  It compounds annually at 5% or more.  I know where I am.  I never have a bad year.”

There was little point in arguing.  For about a decade, the German stock market had meandered up and down.  The deposit contract had probably done about as well and, as he said, without an annoyingly bad year.  Yet what ancient history this meeting appears today.  Within a little over a year, the German stock market had returned 200%.  Since then it has only briefly looked back at the time of the 2002 global bear market and, at the time of writing, is up some 800% since my Cologne meeting –an annual rate of return comparable with the US stock market over the period. 

In 2000, I was designed a retirement plan for a major financial services company in Japan.  Part of the design was to offer the participants a modest guaranteed return on their contributions – an average 1% return per year over their entire working life.   Meanwhile, the funds would be invested in the TOPIX index – Japan’s equivalent of the S&P 100.  Human Resources loved the concept, allowing them to switch out of a very expensive defined-benefit pension formula.  But the head of Risk Management rejected it and, in a global investment business, not so long after the Russian default, the Asian Crisis and the implosion of Long-Term Capital Management, risk management was ascendant.

To illustrate the riskiness of my design, I was given a scenario projection.  The projection showed the TOPIX falling to zero… then staying there.  In fact, in order to show that the new design could cost much more than the old design, it was necessary to keep the TOPIX grinding along the floor.  Otherwise, the fact that employees’ retirements were spread over a couple of generations would largely mitigate the cost of any temporary fall, no matter how severe. 

The TOPIX was around 1,200 at the time of the discussions.  When it descended to around 800 six months later, shortly after the plan has started, risk management described the index as “going to Hell.”  At the time, he had a point.  It had reached as high as 2,800 some ten years earlier.  Yet it was not to descend much further after that and, at the time of writing some six years later, stands at around 1,700.

The point of these two stories is to explain how, at various times and in various markets, the prospects for equities can look wholly unexciting if not downright bleak.  We are not talking about gritting our teeth through a temporary bear market, not knowing when the sun will shine again on the bulls. We are talking about losing any faith that such sunny days will ever reoccur.  And these were not retail investors fretting about their own money.  These were professionals, making long-term, strategic decisions about large pension funds that have investment lives much longer than any individual.  Even if there were brilliant days of sunshine ahead, the specter of long, killing winters would never be far away.  The risk wasn’t worth the possible gain.

The early years of my actuarial career were at a time when the market oscillated around a flat line while inflation ravaged its real value.  Among professional actuaries who advised pension funds, debates raged as to whether there was any point in funding at all.  Even a funding advocate remarked that it was better to have “a melting iceberg than no iceberg at all.”  These were chilly times indeed for fund managers.  When one stated in his report in 1979 that he would expect a long-term, annual return averaging 4% over price inflation, my Chief Actuary laughed and shook his head.  When the first inflation-linked British government bond was proposed, a letter in the Financial Times suggested that they would have infinite worth.

The letter writer can be proven wrong.  But the others, seeming so pessimistic about equities in the light of the late 20^th Century bull market, or Japan’s emergence out of one of the longest-known recessions, were simply learning the same lessons from the past as the hi-tech junkies did during the late 1990s.  Faced with a repeating pattern over years which is observed on a daily basis, it is difficult to imagine a complete reversal that permanently changes the landscape.  We may kick ourselves for missed opportunities, or feel smug and smart about bets that paid off handsomely but, when it comes to the future of the stock market, we really didn’t know.  We got lucky or unlucky.

Does anybody know?  Our first quest is to examine the evidence for market prediction.  This should give us some important clues when we start digging deeply into the workings of the market itself.