Crystal Ball Challenge
Here are some key takeaways:
– Even with advance knowledge of news headlines, predicting market movements is extremely difficult. In a study where participants were given Wall Street Journal headlines a day in advance, about half lost money and one in six went bust.
– Making investment decisions based on news headlines or recent events is generally not advisable. Instead, decisions should be based on factors like base rates, historical data, personal circumstances, risk tolerance, and long-term goals.
– The daily chance of the market being higher is close to a coin flip at 53%. However, over longer time horizons, the odds of positive returns increase significantly – 75% over 1 year and 95% over 5 years.
– Asset allocation should be determined based on an individual’s specific situation, including short-term cash needs, medium-term expenses, and long-term growth requirements. Getting the high-level mix of stocks, bonds, and cash right is crucial.
– Short-term market predictions are extremely difficult and unreliable. The range of possible outcomes narrows and becomes more predictable over longer time horizons (10-20 years), which is more useful for long-term planning.
Crystal Ball Challenge – Links
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Bloomberg – Crystal Ball Challenge
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Crystal Ball Challenge – Transcript
Hello and welcome back to another Mullooly Asset video. We’ve got Tom and Brendan – Bren is filling in for Tim. We appreciate you stepping in and getting back into the fold here; we always appreciate your insights on these episodes.
Hey Case, to be fair, Tim isn’t a regular either – they’re all on a “try-out basis,” right? Always. But it’s good to mix it up though.
You guys are the “core crew” I would say, for the content.
I’m just happy to contribute!
So we’re just going to jump right into it. I’m going to start by highlighting an email I got from Bespoke. They’re a research investing group. I’m not a subscriber, but I’m on their email list.
They always have great market insights and nuggets of good statistics about what’s going on and what we can expect. This was from their Q4 2024 Wealth Management report.
They reference an article in the Wall Street Journal about the Crystal Ball Challenge. And how a lot of young men in their twenties and thirties are in Gamblers Anonymous. Not because they went out to Vegas or AC and lost a lot of money playing cards, but because they’re using options and leverage to try to make money.
They also highlighted a recent study done by Victor Haghani and James White. Victor Haghani, famously of Long-Term Capital Management — which we could do a whole other video recapping what they did.
Basically, the study those guys looked at was called the “crystal ball challenge.” They gave 118 young adults trained in finance $50 each and the opportunity to grow that stake by trading in either the S\&P 500 index or 30-year US Treasury bonds.
The interesting part of the Crystal Ball Challenge was they gave them the information on the front page of the Wall Street Journal – one day in advance. So they gave them the news in advance and then told them to invest based on that. The game covers 15 days, one for each year between 2008 and 2022.
The players in the Crystal Ball Challenge did not do very well. About half of them lost money, and one in six of them actually went bust, which means they lost everything they started out with. The average payout was $51.62, a gain of just 3.2%, which the authors wrote is statistically indistinguishable from breaking even.
The two things that the authors took away from the Crystal Ball Challenge were:
1. The poor results were a product of not being able to guess the direction of the market or bonds very well based on the news.
2. And poor trading size – many of the players used excess leverage relative to their starting asset base. This probably comes as no surprise to you guys, but what are your immediate thoughts about hearing the results of this study?
I’ve got some things to say about the crystal ball challenge, but I’m going to let Brendan go first because he hasn’t been on the show in a while.
Overconfident young men not doing well in terms of gambling, whether that be in cards or slots or with stocks and bonds, is not surprising. That’s the group you would expect to see do this sort of activity, I think, on average.
And yeah, even with information ahead of time, guessing the direction of the market, whether we’re talking about the S\&P 500 or what 30-year yields are doing on a day-to-day basis, is no better than a coin flip. The idea that you’d be able to do it better with information ahead of time maybe is a little bit surprising, but I don’t know. It doesn’t surprise me all too much to hear this information.
The results from the crystal ball challenge doesn’t surprise me either. The first person I heard say this very elegantly was “Downtown Josh Brown.” This goes back over ten years ago, and he said, “You could have tomorrow’s headlines put in front of you – and still not know how the market is going to react to that news.”
And this is proof that you can know the headlines for tomorrow and still not know how the market is going to react to that. That’s so big.
We’ve also seen just an explosion, over the time that I’ve been in the business, of option trading. Now they have zero days to expiration option contracts, and you can leverage pretty much anything that’s out there. You can buy a two times inverse or a three times inverse fund. Still isn’t going to help you.
And when it goes in the opposite direction, the math also works against you there. I don’t want to say dangerous, but they’re really risky and speculative ways to invest. So you’ve got to be careful doing any of that kind of stuff.
So if we’re not supposed to make investment decisions based on headlines or what’s happening in the news or recent events – I think that’s pretty common knowledge at this point in time, and we repeatedly mention that in client meetings, on the phone, talking to people, and in these videos or podcasts – if we’re not making investment decisions based on the news or the headlines, what should we be making them based on?
Base rates, historical data, your own circumstances, and what you need to accomplish with your investments. I think I’d probably start there.
Yeah, I think it’s going to be driven a lot by your own tolerance for risk. How much volatility can you stomach? If you’re a 25-year-old like in this crystal ball challenge, you may be able to withstand more risk, especially if someone just gave you a fictitious amount of money to trade with.
When you’re talking about your own retirement, it’s a very different story, a completely different set of circumstances. Now you may be in your sixties. How much risk do you want to take? How much risk do you need to take? That’s a bigger issue.
Some of the toughest conversations I had going back years in my career were with people who I knew should be taking more risk but were just afraid of losing money or being at risk in the stock market. And then when they finally reached retirement, they were like, “Oh, we’ve got to do something to make this money grow.” That was 15 or 20 years ago.
To piggyback on that, what you’re saying goes to what I said about base rates. So when you have time on your side, take risk, and when you don’t, do not. Looking at what history has provided, the base rates over longer periods of time, and then how much time you have to do something can lead you to a reasonable investment strategy that’s based on something that isn’t the headlines of the day or how you’re feeling that day based on the headlines of the day, because neither of those things are going to be helpful inputs into an investment strategy, I don’t think.
I know that Brendan, you had mentioned in a conversation recently that I think just about every single recent presidential administration has seen at least one 20% drop in the markets at some point during their term. And so we’re getting questions about, “Okay, we’re seeing the blue team swept out and the red team getting put back in office. What’s going to happen?” You know what? The returns, I think, are pretty close to being equal. Nobody can stop the market from going down, and I don’t think anybody in DC causes it to go up either.
And I think that again, you look at history. You look at base rates. Basically, the idea of every administration going back to Herbert Hoover in the ’30s seeing, if you round it up, some of them have seen like 18-19%, but it’s 20% or more over a 48-month window of time.
You’re just talking about the averages of the market because I think that on average, if you look at a decade in the US stock market, you should probably anticipate one or two of those years being down, and probably at least one of them being down in a significant way, not just a few percent. And I think you have to expect that and put an investment plan together that helps you survive it and still accomplish whatever you need to.
Yeah, I think going back to some numbers that we often share, and Bespoke actually highlighted them in their email, the daily chance of the market being higher is 53%. Over one-year time horizons, that goes up to a 75% chance of a positive return. Over five-year time horizons, the odds increase to 95% of the time.
Day to day, it’s a coin flip.
I think speaking to the risk tolerance versus risk capacity conversation, I think we have to strike a balance in our investment blend to survive the short terms, those 20% drops that happen once or twice per decade. We have to be able to withstand those moves in order to get the longer-term returns. That 95% chance over five years – we have to be able to withstand years one, two, three, and four in order to get to that fifth year.
It’s funny, I think the crystal ball challenge that you’re sharing with us is basically trying to dress up the daily odds. Let’s say the daily odds are a coin flip. But also, let’s layer on the fact that these people are trained in finance to some degree, and we’re giving them the news a day ahead of time. And the results are indistinguishable from the base rate, which is just that it’s a coin flip. So if you’re investing on a coin flip, you can just make a distribution curve of how the outcomes are going to go for people.
Like, how many people are going to get heads five times in a row? It’s percentages, and your odds are poor of playing that game and succeeding over the long term. You probably shouldn’t, unless you acknowledge that you’re gambling and you’re doing it with a small portion of your money for entertainment because that’s all that it is.
The Wall Street Journal article that they referenced about the crystal ball challenge had a line in there that was something to the tune of, “If you have to lose $5,000 in a brokerage account trading options to realize that you shouldn’t do that later in life, then that’s the market’s tuition.” And that is worth it. But I guess the point is, don’t do this with any serious amount of money.
I think the interesting thing is the position sizing because I have a feeling we don’t know the events or the information that they shared with the participants in this crystal ball challenge, but I’m guessing that the participants had a feeling that there was some piece of news that they felt was a slam dunk, and they got levered up and bet the house on it. And then it went the other way, and that’s how they lost money.
Speaking to position sizing and rightsizing investment approach, how do we determine how much to invest across the different asset classes that make up our portfolios, or how do we think about those decisions?
I think when you begin with someone that you’re really just getting to know for the first time, you really have to find out where they’re at. There’s money that should stay at the bank. There’s money that should not be exposed to too much risk, and then there’s money that we need for the long term.
Until you get to know a person’s situation, it’s really hard to determine where the lines should be drawn. But once they do get drawn, you have to separate and say some of this money is going to be earmarked for the next year or two of expenses. So we don’t really want to be messing around and taking risk with that kind of money.
The rest of the money we can put away for the future, but you really have to know where a person’s financial skeletons are before you can really answer a question like that.
You’re basically trying to arrive at a mix of cash and bonds and stocks that aligns with when the money is going to be needed. And so even beyond just the next couple of years of expenses, the next several years’ worth of expenses if you’re in the distribution phase, you’ll probably be in bonds beyond just the cash that should be there for the even shorter-term stuff.
And the degree to which you have the stock exposure will depend on what your aspirations are and how much growth you need to have in the plan. Just balancing that all out with what you’re comfortable with, I think, is probably a good way to start the asset allocation discussion in terms of getting the high-level mix right.
And if you’ve gotten the high-level mix right, then I think you’re like 90% of the way there. Obviously, it’s our job to go into the weeds and determine, after you’ve gotten the mix of stocks, bonds, and cash correct, how do you dice it up.
And that’s the part that everybody wants to talk about, but there are many stages before that that get you there. And if you’ve gotten there, it’s probably good enough. Like, it’s – I think you’d be hard-pressed to make huge mistakes at that point from an asset allocation perspective that would really screw it up if you’ve right-sized the rest of it.
That all makes sense. And I just wanted to share one more nugget here from Bespoke’s notes of the crystal ball challenge…
Hey Case, before we move away from that, I just wanted to mention something else. It’s like when people are interviewed or when they are doing a poll question or something like that, a lot of times people will just, for some reason, try to interpret like, “Okay, what answer do you want me to give?” And so when a company like this sets up an experiment, I feel like sometimes it’s like the discussion we have when someone has two brokers or two advisors that are pitted against each other. Like, I’m going to take so much risk to try and outperform anybody else.
The numbers are going to be skewed. And so if someone is placed into an experiment like this crystal ball challenge and they’re given $50 and they can day trade this money, I think sometimes they know that it’s not their own money at risk, and so they’re just going to swing for the fences. And they’re going to take risks that they would not do with their own money out of their own pocket. What do you guys think about that?
It’s impossible to strike bias from a test. I think the results are directionally correct. And I think the point is that it’s dumb stuff you shouldn’t be doing with your own money, hopefully.
So I hope what you’re saying is true in a sense that people wouldn’t do this sort of activity if they weren’t part of the study. But I think maybe it’s there to discourage overconfident young men from thinking that they can do this.
But I’m not sure the sort of person who ignores base rates to begin with is going to be persuaded by statistical data since they’re ignoring it already.
I think it just runs counterintuitive to how some people think about the market. If only you were “Biff” from “Back to the Future” and had the Grey’s Sports Almanac and had tomorrow’s news, you could make a lot of money doing that.
That’s a good one.
Like, it doesn’t necessarily work out the way that you think it’s going to. We’re coming off of 2024, and it was back-to-back years in 2023 and 2024 of the S\&P 500 being up more than 20%.
And this is, you know, that nugget from Bespoke’s research that I’m sharing. So we’ve seen this happen three times previously in the S\&P’s history. One time it was down big the next year – it was down 39% in 1937. So it’s going way back.
It was relatively flat in one year, up 3% in 1956, and the other time it was up big again, up 31% in 1997. So the point being that if you think the market is going to go one way or the other just because of what’s happened the last two years, you probably shouldn’t think that way.
Who knows? Is the answer. Look at the range of outcomes there. What do you do with that information? It’s not useful.
Plus 31 to down 39 – I mean, you could drive… You know what that sounds like? It sounds a lot like the distribution of returns that you can expect based on historical S\&P 500 data.
Shrug emoji. Forecasting one year out is really difficult. You can look at the range of returns, and it’s about the range that you just alluded to in terms of down a bunch to up a bunch, but when you go out to 10, 15, 20-year periods, the range of possible outcomes starts to converge and become more predictable.
And that’s what you can plan with, and that’s what you can make investment plans for the long term with. But again, to your point earlier, Case, you’ve got to be able to survive the short term where these ranges are a mile wide, and that’s why you diversify and you don’t hold all your assets in one asset class. You have other shorter-term places to hedge that risk of the stock market’s unpredictability in the short term.
Truth. We’ll see you on the next one.
