If we have discovered a way of making gold from any old iron, would we tell the world about it? Probably not. We would most likely keep it to ourselves and in the process make ourselves outrageously wealthy.
If we found a legal way of picking winners at the racecourse, would we shout it out to everyone? Why would we. We would more than likely keep our mouths shut and quietly make ourselves very rich, very quickly.
Of course, nobody has found a way of turning iron into gold or discovered a sure-fire way of picking winners.
So, here’s the thing: if we have found a way of accurately predicting the direction of share prices, would we announce it to all and sundry? Again, probably not. Why would we share something as valuable as that with the world.
We would most likely bet the farm using our new algorithm over and over again and make ourselves exceedingly rich in the process.
Unfortunately, though, there is no guaranteed way of making money in the stock market. Not in the short term, at least. If anything, in the short term, share-price movements can be highly unpredictable.
There is no formula that we can apply that will guarantee us success every time. Looking at historic data does not help us find future winners. That is why shares are by nature risky. If we are looking for guaranteed returns, then cash in the bank could be a better option. Government bonds are probably another.
Point is, making money from shares is never guaranteed. That is why there is a risk premium attached to investing in the stock market. It is called the equity-risk premium.
The equity-risk premium is the excess return that we get from investing in the stock market over a risk-free rate such as US 10-year Treasuries. That excess return should compensate us for taking on the higher risk of equity investing.
As investors, we must take risks if we want to earn a higher rate of return on our money. The equity risk premium, which can be different for every share and for every market, can be a guide as to how much more return we can expect compared to a risk-free rate.
Imagine what it means if we could know for certain what a share will do. Firstly, it would mean that every piece of data we use is perfectly accurate. Secondly, it means that we can know – in an unknowable world – what will happen before it has happened.
Neither of those two statements is true, unless we are Marty McFly. So, beware of geeks bearing formulas, even if they claim that they are backed by artificial intelligence. If the alchemy was really that infallible, do you really think they would tell you?
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Disclosure: David Kuo does not own any of the shares mentioned.
