Market Declines, Randomness, and the Financial Press

Every so often, the stock market incurs a downturn, and many in the financial press (print and on line) react with typical restraint and thorough analysis, producing headlines such as “The End of the Bull Market,” and “Stocks Set for Huge Decline.” Although logical reasons are given for these predictions (political uncertainty, fear of deficits, disappointing economic results), these analyses typically have three aspects: 1) they are more relevant to the past decline in the market than potential future movements, 2) they leave me with the desire that these experts had shared their wisdom before the decline started, and 3) they provide seemingly amazing statistics to heighten the importance of the event.

Nearly every market analysis on Wednesday contained the statistic that the market had declined for eight consecutive days (similarly, tomorrow we will read about how the market “plunged” by 5% today). How unusual is such an occurrence? The answer is not that rare. And such an occurrence is totally consistent with the randomness of markets. If you have a few minutes to waste, perform an experiment – take a coin, and keep flipping it until you get eight consecutive tails. See how long it takes. The answer will be surprising – on average you will get the 8th tail by the 185th flip. Indeed, basic statistical analysis suggests that you should get eight straight tails every 256 flips. Applying this result to stock markets, if pure randomness was driving daily returns, stocks should decline for eight consecutive trading days about once per year. So this headline-making occurrence should be as surprising as seeing “Summer Heat Wave hits Phoenix.”

So if these occurrences are not that rare, why do journalists talk about them so much? The answer is because the fundamental role of journalists and bloggers is to get you to read their articles. If the headline was “Stocks have Very Normal Decline” - would you have read on? The vast majority of articles about the stock market are not meant to help you make investment decisions – they are written to entice you to read them. That is why I seldom suggest sending them to our clients.

This is not to say that there isn’t risk of continued short-term declines. There are legitimate concerns about the world economy. But, if you are investing in the stock market, you are always susceptible to significant short-term declines. Sometimes they occur, but most times they don’t. The question is do you disrupt your long-term investment strategy because of these short-term risks. Our recommendation is unequivocally: NO.

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