Last week, we talked about the financial industries’ endless quest to find a way to develop reliable market forecasts. A fundamentally new way of thinking has evolved from a field far removed from economics or finance and offers a strong argument why those current models are destined to fail.
The field, known as complexity science, is dedicated to the study of “complex systems” in our world. For the last few decades its analytical techniques have been applied principally in the natural sciences to study processes as diverse as the workings of the human mind and the spread of disease.
When describing systems, experts are careful to distinguish between the terms complicated and complex. Complicated systems may be large and intricate but their components can be studied piecemeal to determine how a change in one will affect the entire system. Sending a rocket into space and back is an example of highly skilled experts working within complicated systems.
A complex system on the other hand is comprised of interdependent parts that are continuously adapting to changes within the system. A small change in one component can unexpectedly morph into a large-scale event. Complex systems do not lend themselves to precise analysis because there are no identifiable relationships among the parts or between any individual part and the system as a whole. The connections between the contributing forces and future outcomes are too tenuous and variable to be predictable. Therefore, depending on the interactions within the system, similar conditions can yield dramatically different results.
So what does all of this theory have to do with forecasting the twists and turns in the stock market? As it turns out, quite a lot. It presents another serious challenge for professional forecasters. Increasingly, the global markets are viewed as classic examples of immensely complex systems. They consist of hundreds of governments and millions of institutional and retail investors, pursuing different goals, reacting differently to world events, generating millions of interactions and creating wholly unpredictable outcomes. The combination of possible interactions and outcomes are infinite, ranging from the extremes of speculative market bubbles and crashes to everything in between. This complexity is ever-present, creating uncertainty even when the markets are stable and appear to be behaving in a predictable manner. The evidence produced by economists, scientists and mathematicians is impossible to ignore: the world’s financial markets are complex beyond our cognitive abilities and fundamentally unpredictable.
Unfortunately, evidence against forecasting is unlikely to diminish its popularity. For the experts, too much is at risk. Admitting that they just don’t know where the markets are heading over the next month or year would be a threat to their existence. To the gullible investor, they will continue to offer the illusion of simplicity and certainty in an otherwise complex and uncertain world. Informed investors and those who take logic and evidence seriously, however, will acknowledge that the future is simply unknowable.
Accepting the fact that we can’t predict the future doesn’t mean we should ignore it. Smart people build plans that minimize the importance of predictions. They leverage the variables within their control, anticipate a range of possible outcomes and then mitigate the damage of extreme events. For investors intending to fund important future goals, that means controlling how much they spend and save, designing a portfolio that reflects their personal circumstances, and responding sensibly to the inevitable surges and drops in the markets. We may not be able to control the future, but we certainly can plan for it.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions. John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.