To predict the most likely scenarios for financial markets is to project on the basis of past incidents. Predicting is deterministic, i.e. builds on consistency of rules.
Predicting implies consistency of rules ...
Consistency of rules can initially appear acceptable for the only thing we have reasonable certainty on when it comes to our physical universe is that it can described with high accuracy through mathematics, in particular on an aggregated level.
But in a system of many million actors and multiple dimensions, incl. time, it takes a lot of projections including for interactions. This produces a data overflow and therefore it is necessary to prioritise the projections. This blurs our description of the world. In physics this phenomenon is called entropy, i.e. disorder.
If we base our projections on average (norms) and thus on an aggregated level, we still need to prioritise what norms we weigh higher than other. Do we e.g. believe that market movements are the particular result of:
- inner consistencies of rules and cyclicalities (momentum investing) ?
- individual companies' performances (fundamental investing) ?
- certain actors' decisions (political) ?
- all actors' shared consistency of rules (sociological) ?
In all instances we still need to account for the interaction, i.e. the individual weights of norms among themselves.
... and requirements of the predictor
Finally the quality of predictions depend on the interpreters ability to interpret data. This ability can be conscious or unconscious.
Omkring den bevidste del skrev George Orwell f.eks. i bogen “1984”: “Den, der kontrollerer fortiden, kontrollerer fremtiden. Den, der kontrollerer nutiden, kontrollerer fortiden”. Med dét mente Orwell især, at den måde vi beskriver fortiden på, afhænger af vores mål i dag. Vores bias påvirker dermed vores vinkel på fortiden, og får derigennem påvirkning på fremtidens udfald.
But even if we address an issue with pure motives we are affected by our bias. Here there is a tendency to the "Dunning-Kruger effect". When we know a little bit we feel sure (”Mount Stupid”), but as we learn more and more, we realise that we know all too little (”Valley of Despair”), until we are slowly more enlightened. In the words of Socrates (according to Plato): "I am the wisest man alive, for I know one thing, and that is that I know nothing."
On financial markets there are thus only two rules of consistency that it makes sense to adhere to: Return equals risk plus that entropy increases over time (cf. Boltzmann).
So why even try to predict? The answer to that is probably simply, that is in human nature to seek simplicity and rationale in information overflow and disorder. This also applies although we know, that it is unrealistic. The blindfold from projections is our sociological way of staying calm, a deliberate accept of risk.