Investors search for patterns in stock movements
— -- Q: Is it more likely the stock market will fall on the fourth day if it fell the previous three?
A: The chaos of the stock market can be alarming for investors. What could be more unnerving than to think you've put your money into a market that's random and unpredictable?
Hoping to rationalize the discomfort of the market's random short-term moves, investors are on a constant search for patterns. They're trying to find signs that would somehow comfort them and make them feel they somehow know what's next for stocks.
Your theory is just as good as most that I hear. If the stock market is in an undeniable down trend, with sellers pushing it down for three-straight days, wouldn't it be likely for markets to fall a fourth? Sounds logical, right?
Alas, it's not true. Stocks have fallen three days in a row 2,428 times, based on the history of the Dow Jones industrial average going back to 1928. What happened on the fourth day following these undeniable downtrends? Stocks were higher 1,278 times or 52.6% of the time. They were lower on the fourth day 1,150 times or 47.4% of the time.
In other words, the fourth day is essentially a coin flip between up and down. It's not a 50-50 split, but pretty close. The stock market's general upward bias over time, due to rising corporate profits and perhaps inflation, are possible reasons why the fourth day is slightly more likely, historically, to be up than down.
What does all this tell us about investing? You may discount it as just an interesting backward-looking exercise that's not meaningful beyond that. Discounting this analysis would be a mistake, though, because it contains a very valuable insight for investors.
Day-to-day movements by stocks are unpredictable and random. Short term movements in stocks are dictated by news events, both positive and negative, which are not yet factored into stock prices because they're a surprise. If you believe it's impossible to know what will happen from one minute to the next, you, too, must believe it's impossible to know which direction the market will move in the short term.
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