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Trendspotting

One of the greatest misconceptions investors have embedded in their psyche is the assumption that predictions about the future are accurate, or even valuable. I struggle with it too. To the extent that many other investors have the same information and believe the same thing, the value of opining and acting on what is to come is often moot. I'll give you a personal experience to illustrate the point.

I have several friends who are deep into the mortgage business. With ultra-low interest rates, business is booming with active buyers and sellers, along with refinancing. We all surmised that when Rocket Mortgage went public earlier this year, the price might not have reflected how fantastic the upcoming quarterly report might be. I bought stock and call options in what I thought was a move ahead of this trend.

As it turns out, Rocket did report eye-popping results. The prior quarter resulted in a $50 million loss, and the recent quarter was a $3.5 billion profit. Unfortunately, the consensus was expecting a $3.8 billion quarterly profit, and the stock promptly lost 20%. How can that be?

We are all aware of the possibilities related to the trends we see around us. It might be Amazon packages stacking up on our front porch or the new gadget we love. But in order to make money from the trends we see, the actual future of the business must exceed the aggregate expectations of everyone else, not just you. This reality essentially makes the chess game three dimensional. You cannot create a winning chess strategy based only on your opponent's moves. That's checkers. The game of investing is far more complex than that, and the moving parts in the stock market are like chess on steroids because asset pricing means that the board moves too.

This concept is mind-bending because equilibrium pricing reflects the cumulative effect of buyers and sellers, many of whom already believe what you believe. Additionally, company employees who have far more firsthand knowledge than you can trade their company's stock in their own accounts, provided they are not in control of the company nor have access to information from those control insiders. These employees can watch the pebble enter the still water and recognize the ripples early on. They aren't seeing the ripples that have reached the beach by reading conjecture in Money magazine six months too late.

This example explains how one can nearly perfectly predict the future and still lose money. Predicting, qualifying, and quantifying other investors' actions emerges as a more important concept. You can only achieve excess returns from mispricing by others, not from correctly observing a trend and figuring out what companies should benefit. This would only work if current price didn't matter.

Trendspotting investors tend to lose track of how damaging those losses are when reviewing their track record. Just like my score of 38 on my first introductory algebra exam turned all my future A's into a C average, trend spotters like to consider themselves "A" students, deceiving themselves all the while.

Trendspotting turns investing into a game we enjoy playing, and we justify our results accordingly. But when it's all said and done, those who play the game this way will capture far fewer kings than other methodologies.