There Are No Random Events

"Turning back is how the way moves." ~ Lau Tzu

Investors and traders often argue as to whether stock price movement is random or not:  The prior camp believes price movement is unpredictable, and thus a passive, buy-and-hold investment strategy is prudent; and the latter believes price movement is predictable, and thus an active trading strategy is prudent.

Volumes of books have been written and millions of pixels have been posted to the Internet arguing, often quite convincingly, both for and against the idea of randomness as it pertains to investing.

In true philosopher fashion, I will not explicitly tell you which side you should choose; but rather I will share a story first, and make a few points afterward:

This is from Eckhardt Tolle's book, A New Earth: Awakening to Your Life's Purpose :

The interconnectedness of all things and events implies that the mental labels of 'good' and 'bad' are ultimately illusory.  They always imply a limited perspective and so are true relatively and temporarily. 

This is illustrated in the story of a wise man who won an expensive car in a lottery.  His family and friends were happy for him and came to celebrate.  'Isn't it great!' they said.  'You are so lucky.'  The man smiled and said, 'Maybe.'

For a few weeks he enjoyed driving the car.  Then one day a drunken driver crashed into his new car at an intersection and he ended up in the hospital, with multiple injuries.  His family and friends came to see him and said, 'That was really unfortunate.'  Again the man smiled and said, 'Maybe.'  While he was still in the hospital, one night there was a landslide and his house fell into the sea.  Again his friends came the next day and said, 'Weren't you lucky to have been here in the hospital.'  Again he said, 'Maybe.'

The wise man's 'maybe' signifies a refusal to judge anything that happens.  Instead of judging what is, he accepts it and so enters into conscious alignment with the higher order.  He knows that often it is impossible for the mind to understand what place or purpose a seemingly random event has in the tapestry of the whole.  But there are no random events, nor are there events or things that exist by and for themselves, in isolation.

This story of the wise man is a modern version of an old Taoist lesson on fu, which is a Chinese word for return; a principle stating that all extremes return to a state of equilibrium or balance with their opposites.

The perpetual argument between investor and trader as to whether or not stock prices are random, in my humble opinion, makes most arguments on both sides wrong; or, at a minimum, only partially right. 

In the short-term, the movement of stock prices appears random ("good luck" or "bad luck" in isolation), primarily because precise and consistent predictability is nearly (or apparently) impossible.  Over time, however, stock prices will return to equilibrium or, in investor jargon, "revert to the mean."

Dogmatically stating that stock price movement is either random or not random can be dangerous.  Randomness, or chaos, is part of the natural order of things, which paradoxically makes the big picture of nature (and the stock market) non-random -- predictable chaos, if you will.

Price fluctuations in the short-term and price reversion over time makes success possible for either a passive or active (or combined) investing strategy.  This explains why there are many examples of investors and traders demonstrating their success at adhering to the ideas of either randomness or non-randomness in their investing and trading strategies.  Both can be "right."  It is only in poor application that one or the other can be wrong.

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Sources:

Tao Te Ching (Penguin Classics)

A New Earth: Awakening to Your Life's Purpose

Related:

Dogma Deconstruction & Abstraction Subtraction

Comments

[Maxjpucher]

Great post.

Yes, the mean is a natural tendency which is when we observe anything over a longer period we can always observe it. But the point is that this statistical mean does not create a predictable scenario. It is an observation only.

Statistics can't predict the future and therefore tomorrows stockprices are from a current perspective random. When I look back at them they look statistically aligned.

Hindsight is always 20/20. But even hindsight can't discover the true causal relationships of universally connected entities. And thus the future remains uncertain!

PS: Quantum physics discovered the very same thing that Lau Tzu described.

[Kent @ The Financial Philosopher]

M:

It's interesting that Quantum physics "discovered" something Lau Tzu knew intuitively.

Thanks for the comment...

[Mike S]

Statistics can't predict the future, but probabilities can. Contrary to the statement "there are no random events", I believe that ALL events are random. Consider a deck of 52 playing cards. When they are adequately shuffled, the order is completely random. As they are dealt into groups, or hands, they form sets of various value (depending on the game you are playing). Some hands have a high probability of winning while others have a low probability of winning. If a player consistently plays high probability hands, in the long run he will win. In the short run anything is possible. How is this fundamentally different from the stock market? Or any other endeavor in life? If we consistently put ourselves in high probability situations (the good hands we are dealt) and reject the low percentage situations ( the poor hands), the outcome will be predictably positive... if we stay in the game long enough (Warren Buffet says 40 years is a short time frame!). And remember, the hands were dealt to us completely at random... our only choice is how to play them.
I marvel daily at the randomness of the Universe and I am delighted that the future remains uncertain!

[Kent @ The Financial Philosopher]

Mike S:

As with much philosophic ideas and discussion, the objective is to provoke thought by questioning conventional understanding. In that regard, my post title, "There are No Random Events," provoked thought!

Your comment certainly makes me think as well, so thanks for that.

I do agree that life is full of randomness but the overall movement of humanity is cyclical in terms of things being built and destroyed; things moving up, down, in & out.

Think of the movement of ocean waves or even your breathing.

The stock market, for example, mimics nature because it is a result of nature -- human thought -- therefore, each market cycle is one of building and destroying; reversion to the mean.

The small events are random but they are contained within an order that is not random. This idea is captured in your statement: "If a player consistently plays high probability hands, in the long run he will win. In the short run anything is possible."

The big picture is non-random but the small events that create it are random.

Any other thoughts?

Thanks for commenting...

Kent

[Janel Booker]

I'm thankful for your post at Get Rich Slowly, otherwise I wouldn't have came across this post. It truly confirmed a belief that I've been contemplating for a very long time, there is no such thing as good or bad, all that matter is your judgment.

My latest quote is, "there is no such thing as good or bad decisions. A decision can create favorable or unfavorable outcomes due to the circumstances that surround it." I think in order to understand life, we need to have sound perspective on why things occur and being prepared to deal with those occurences. This post really hit the nail on the head. Thank you.

[Kent @ The Financial Philosopher]

Janel:

Thanks for visiting The Financial Philosopher! I enjoyed writing the post at GRS.

I agree with you that "there is no such thing as good or bad." Humans have a weakness of constantly trying to categorize and compare. The idea of "good or bad" is only one of relative comparison.

When you stop trying to categorize and compare things, you stop defining them as good or bad, strength or weakness.

Thanks for the comment...

[Mike S]

Janel:

You are correct that in nature there is no "good" or "bad"... there are only consequences. And these consequences are usually a result of a decision that is made based on our judgement of the situation at hand. However, I believe that there ARE good and bad decisions. "Good" decisions are those where, after considering the facts at hand, you choose the action that has the highest probability of a favorable outcome. A "bad" decision is just the opposite... you choose an action that has low probability of a positive outcome. Now, a good decision can have a negative outcome and vise versa (ask any card player!) A lifetime of good decisions does not necessarily guarantee us health, happiness, and prosperity. But what else are we to do? Choose a low probability action and hope to get lucky? My personal philosophy is to try to place myself in high probability situations and hope I can avoid the Black Swans.

Since this is a financial blog, I will tell you that I have recently rid myself of all individual stocks and have moved to a asset allocated portfolio of ETFs. (I hope that turns out to be a "good" decision!) At least now I don't worry about the ups and downs of the market and can instead ponder important things, like is there "Good" and Bad" in the Universe?

[Kent @ The Financial Philosopher]

Janel & Mike:

I believe one can only know if a decision is "good" or "bad" in hindsight; however, what I believe Mike is saying, is that one can use "good" or "bad" judgment.

Judgment is used to make decisions but this judgment can only be made based upon knowledge and experience; therefore, two people can make opposite decisions (choices) fully believing they've made the right choice.

Hindsight will reveal which decision was best.

Regarding your ETF decision, I believe you've made a decision based upon good judgment!

"To prefer evil to good is not in human nature; and when a man is compelled to choose one of two evils, no one will choose the greater when he might have the less." ~ Plato

[Mike S]

Kent:

If you are presented with a wager that gives you an 80% chance of winning, it is always a "good" decision to take the wager (unless the 20% of the time that you loose will bankrupt you, but that's a different discussion). That's why buying a lottery ticket is always a "bad" decision (the odds against you are so great that if anyone but the state were selling the tickets they would be put in jail!) So, you can be an 80% favorite and still loose, or you can be a 13 million to one underdog and win. Regardless of the outcomes, the decisions (choices) were still "good" and "bad" respectively. Hindsight won't tell you which choice was best. It will only give you the resulting outcomes for those particular choices. If you make a bad decision that has a positive outcome, it was still a bad decision... you just got lucky, that's all.

Of course the real problem in life (and finance) is that our considerations are very seldom that clear. We can't "know" that we are an 80% favorite when someone asks us to make wager, or as the stockbrokers put it, an "investment". Remember, for every share of stock that is purchased because someone thinks the price is going to go up, someone is selling because they think the price is going to go down (two people making the opposite decision, both fully believing they are right ... or at least believing that their stockbroker is right). My personal financial plan is to let the buyers and sellers do their thing and keep the market efficient. I'll take the average less expenses (hence the ETFs).

In my personal life, when I am compelled to choose between one of two evils, I'm going to choose the one I haven't tried before (credit Mae West for that one!)

Thanks for the conversation...

Mike

[Kent @ The Financial Philosopher]

Mike S:

Great points! We return to another theme of this blog, which is to define things for yourself and to transform abstract meanings into the concrete so that an individual can make personal, conscious decisions.

One person might believe that paying only $1 for a lottery ticket is not a "bad" choice, especially if the dollar does not take away from the necessities of living. It's only one dollar! Would it be a better choice to use that dollar to buy a can of soda, which is arguably less healthy than the lottery ticket?

Another person would argue that the odds are 200 million to one of winning so purchasing the lottery ticket is indeed a bad choice.

I agree with your points. I just couldn't resist the philosopher in me to make another point that each person must make conscious choices based upon their own rationale.

This happens to be a theme of a post I will publish today (July 21, 2010) on ego and making conscious choices with money.

Thanks to you for the discussion as well!

Kent