Forecasting or Coin Flipping?

“People have always had this craving to have someone tell them the future. Long ago, kings would hire people to read sheep guts. There’s always been a market for people who pretend to know the future. Listening to today’s forecasters is just as crazy as when he king hired the guy to look at the sheep guts.” – Charlie Munger

The following story comes from a book from the late 1980s called Why The Best Laid Investment Plans Usually Go Wrong by Harry Browne.  It’s a great illustration of the folly that is trying to take advice from those offering short-term market outlooks.  He actually adapted the story from an episode of Alfred Hitchcock presents.  It’s done in a tongue and cheek way but it’s probably not too far off for some investors.  Here it is (hat tip to Craig for passing this one along):

There was something strange in Mr. Jones’ mail on Monday. It was an envelope, with no return address, that contained a single sheet of paper – which was blank except for one sentence:

The stock market will go up on Tuesday.

Mr. Jones checked the stock market’s close on Tuesday and was amused to find that, indeed, the stock market had gone up. On Thursday he received a second note, saying simply:

The stock market will go down on Friday.

He watched the market with more interest on Friday, and felt a twinge of excitement when he saw it drop. On the following Monday, Mr. Jones received a third letter. He tore open the envelope and read:

The stock market will go up on Tuesday.

He called his broker immediately. He placed an order to buy a stock index option just before the market’s close that day. He gave a second instruction, to sell the option just before the close the next day, Tuesday.

On Tuesday, Mr. Jones left work early and spent the rest of the day at his broker’s office, watching stock prices pass across a video screen. The market was up and Mr. Jones made a profit of $500. On Thursday a fourth letter came:

The stock market will go up on Friday.

He called his broker again, and this time he bought six options. As promised, the market rose on Friday, although not as much as it had on Tuesday. Still, Mr. Jones showed a gain of $1,300 on his six options. For the week, he had a profit of over $1,800.

Mr. Jones didn’t go to work for the following Monday or Tuesday. Instead, he stayed home to wait for the mail.

He had no idea how someone could forecast the market so well. How did he do it? Did he use a computer? Did he have inside information? Did he eat a fortune cookie every day?

But what difference did it make how it worked? The important thing was that it did work. On Tuesday another letter came:

Now you know that I can forecast the market perfectly. To learn what the market will do next Monday, send $500 cash to Mr. John Smith, c/o General Delivery at the downtown post office.

Mr. Jones immediately went to his bank to get the cash. He put the money in an envelope as instructed, and took it directly to the downtown post office for mailing. On Friday he received his fifth forecast:

The stock market will go down on Monday.

He called his broker and arranged to buy ten stock index put options – an investment that would profit if the market went down. And the market did drop on Monday, giving Mr. Jones a one day profit of over $4,000.

The next letter asked for a $1,000, which Mr. Jones gladly paid. He received the sixth forecast and won another $4,500.

The following letter asked for $2,000. Mr. Jones paid, received the seventh forecast, doubled his bet, and won over $6,000. The mysterious forecaster had correctly called the direction of the market seven times in a row.

What a genius!

The next letter he received asked for $3,000. He paid the money and received the eighth forecast, which said the market would go up on Wednesday. But the market went down. He lost $4,000 on his options.

Even after the loss, Mr. Joes was still $5,800 ahead. He was ready, even eager, to pay for the next forecast. After all, the mysterious John Smith had been right seven times out of eight – which was far better than Mr. Jones had ever done on his own. But Mr. Jones never received another letter.

On the day after Mr. Jones took his loss, John Smith entered into his computer the news that the market has gone down. The computer, for the eighth time, deleted half the remaining names from Mt. Smith’s mailing list.

The list was very short now. Three weeks before, it had contained 65,536 names and addresses; now there were only 92 left. Soon the scheme would be over.

For the first mailing, the computer had addressed envelopes to 65,536 people. The envelopes were stuffed with notes: 32,768 saying, “The stock market will go up on Tuesday,” and 32,768 saying “The stock market will go down on Tuesday.”

When the market rose on Tuesday, the computer deleted the names of the people who had received the “down” letter. A similar routine was repeated after the second, third and fourth letters, with the computer deleting half the names each time – the names of the people who had received the losing forecast.

After the fourth letter, the list was down to 4,096 names. To them, the computer addressed envelopes stuffed with the “Send $500” letter. Surprisingly, 1,481 people responded by sending Mr. Smith $500 to pay for the forecast.

Of course, only half those people (740) received a correct forecast. Those winners were asked to send $1,000 for the next forecast – and 739 of them did.

Of these, 370 received a correct forecast and were kept on the mailing list. After the “Send $2,000” letter and its forecast, the list was down to 185 names. Mr. Jones was dropped from the list when his $3,000 forecast happened to be on the wrong side of the market. Even then, there were still 92 people who had received eight correct forecasts.

The ninth forecast reduced the list to 46 winners, and the tenth forecast cut it to 23. By then, Mr. Smith had received over $3 million from grateful and admiring investors.

After thinking it over, he decided to end the scheme there. He had become so fascinated with the stock market and with mail-order advertising that he decided to publish an investment newsletter instead.

He contacted the 23 people who had received ten consecutive winning forecasts. Each of them was delighted to write an endorsement praising Mr. Smith’s “incredible track record.”

Source:
Why The Best Laid Plans Usually Go Wrong

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