20/20 Money: See the Markets Clearly and Invest Better Than the Pros

Chapter 6. FORECASTING, PART 1—THE PRINCIPLE OF PROBABILITY

	Prediction is very difficult, especially if it's about the future.
	--Niels Bohr

	Weather forecast for tonight: Dark.
	--George Carlin

Stock market forecasting is a difficult subject. To understand how it works we're going to have to dig into some esoteric ideas and sometimes vexing logic.

Forecasting is not a footnote to market analysis—forecasting is a kind of analysis that has its own set of methods independent of economics and markets. So the first thing we must do is explore ideas about how forecasting works generally before considering stock market forecasting specifically.

This is the first of two chapters about forecasting. This one is about probability; the other is about pattern recognition. Both are discussed in context of CEAS—Chapter 5's topic. These two ideas—probability and patterns—can sometimes contradict one another, and there are many experts who sit squarely in one camp and disparage the other. Ultimately though, pattern recognition and probabilistic thinking can be used together to help us forecast stock market outcomes. Understanding them both, then putting them together, is the project of these next two chapters.

FORECASTING IS STRANGE ALCHEMY

In the dark ages, alchemists had formulas and strict rules for making potions and alloys. Proportions and measurements were quite precise. But at the same time, alchemic rituals were also about the unquantifiable, the spiritual—it was about getting an alchemist's ...