By Jason Zweig | Oct. 21, 2016 7:48 pm ET
Image credit: Utagawa Kuniyoshi, “View of Onmaya Embankment in the Eastern Capital” (ca. 1831), Museum of Fine Arts, Boston
Here’s a column I wrote in 2002 on Murphy’s Law of Investing: whatever you buy will go down right after you buy it, and whatever you sell will go up right after you sell it. Why does that seem to happen so often? The most common cause is the First Law of Financial Physics: regression to the mean.
Murphy Was an Investor
Money Magazine, July 2002
Why does it seem that whatever can go wrong will go wrong?
A few days ago, I met an investor who was downright distraught. “I watched Cisco for years,” he said, “and I kept refusing to buy the stock because I thought it was overpriced. But it kept going up. And up. And up. So finally [in March 2000] it hit 80 bucks a share and I just couldn’t stand it anymore, so I bought it.”
He shuddered at the memory: Right after he jumped in, Nasdaq crashed, Cisco ran into inventory problems and its stock came down like a boulder kicked off a cliff. “For two whole years,” the investor fumed, “Cisco kept dropping until I was totally sick of that stinking stock. So I sold it for 13 bucks at the beginning of May.” He paused, then hollered: “And guess what? The very next day, Cisco announces good earnings and the stock goes up 24%! In a day! Am I cursed?”
We all shake our heads over the apparent workings of Murphy’s Law (“Whatever can go wrong will go wrong”) and its corollary (“…in the worst possible way at the worst possible time”). We tend to believe that it will rain whenever we forget our umbrella and be sunny whenever we lug it along, or that whichever checkout line we stand in will turn out to be the slowest.* But does the perverse logic of Murphy’s Law govern investing too? And is the whole concept merely a cleverly expressed superstition, or does it have some basis in fact?
I recently met with the world’s leading authority on the science of Murphy’s Law — yes, there is such a science, and such a person — and learned that it is often profoundly true, in surprisingly powerful ways. And it applies to investing more broadly than anyone could have imagined in the bullish days of early 2000. But by understanding the financial physics of Murphy’s Law, you can improve your odds of staying out of its destructive path.
The case of the tumbling toast
Who is the maven of Murphy’s Law? Robert A.J. Matthews is very British, and not just because he has two middle initials and makes a mean cup of tea. Matthews, 42, also has the English knack for taking essentially silly things especially seriously. An Oxford-trained physicist, Matthews doubles as a science columnist for the Sunday Telegraph of London. But his abiding love is for the ironies and accidents of science. So Matthews set out to investigate one of the oldest examples of Murphy’s Law: Why does bread always seem to land buttered side down when it falls on the floor? You might think it’s because the buttered side is heavier; a psychologist might argue that it’s because we’re more likely to remember a wet landing than a dry one; a skeptic might claim that the odds of a buttery impact are always fifty-fifty. It turns out that you’d all be wrong.
“Like most people, I guess,” says Matthews, “I thought it’s a fifty-fifty chance, unless you’ve got a pound of jam on one side.” But last year Matthews enlisted 10,000 schoolchildren across England to tip buttered toast off plates. Just over 62% of the time, the bread landed butter first — a percentage much too high, across so many trials, to be the result of chance. Matthews easily ruled out the weight of the butter as a cause: toast that was unbuttered but inscribed with the letter B in magic marker still landed with that side down.
So why does toast so often go splat on the wrong side, and what on earth does this have to do with investing? Matthews’ explanation is both simple and profound: “The universe is designed against us,” he says. Given the typical height of tabletops (29 to 30 inches), there isn’t enough room for a tipped piece of toast to make a full rotation before it hits the floor. So why are tabletops so low? Because humans average less than six feet tall. And why is that? If we were much taller, explains Matthews, “our heads would hit the ground with so much energy that it would break the chemical bonds forming the linkages in our skull,” and we would die from slipping or falling. “These relationships between mass and force are fundamental constants of the universe,” he says, “set in place not long after the Big Bang.”
Does investing have its own fundamental constants? By March 2000, when our Sad Sack bought in, Cisco had returned an annual average of 98.6% over the previous 10 years. But studies have consistently shown that the outer limit of long-term earnings growth is about 20% — and that even 15%, over a decade or more, is barely achievable. Why? There have to be physical limits to how fast a company can grow. Consider: For a company with $1 billion in revenue to double in size, it need only sell an additional $1 billion of its goods or services. But once that company reaches, say, $50 billion in sales, doubling becomes a Herculean task; for one thing, such a giant firm will eventually run short of new customers and markets. And if Cisco had managed to grow at 98.6% for the next 10 years, the stock would have mushroomed to a total market value of $520 trillion by 2010 — at least 20 times the combined value of every stock on earth in March 2000.
That absurd result shows why extreme growth must carry within it the seeds of its own destruction. As Warren Buffett quips, “Nothing recedes like success.” That highlights Murphy’s Law of Finance: A stock or fund return much higher (or lower) than average must, sooner or later, fade back toward average.
This tendency for trends to reverse is called regression to the mean — and anyone who ignores or denies it is doomed to disappointment. Whenever you gamble that a very high (or low) return on a stock or fund will continue, the odds are toweringly against you. Only by taking more moderate bets can you get the odds back in your favor and Murphy’s monkey off your back.
The umbrella enigma
Some of Matthews’ other findings also apply to investing. He points out that a great Cambridge mathematician, G.H. Hardy, believed in Murphy’s Law of Umbrellas. “Hardy was convinced that there is a malevolent rain god,” says Matthews, “so he would send an assistant outside carrying an umbrella to trick the god and ensure that it wouldn’t rain on Hardy’s cricket match that day.”
But even in England the odds that it will rain during any given hour of the day average about 10%. So, even when the forecast is for a 100% chance of rain that day, the odds of rain at any particular hour are much lower. Therefore, most of the times you lug an umbrella because of a rainy forecast, you’ll end up never opening it (and those times will stick in your selective memory).
That’s what statisticians call a “base rate” problem: All too often, we forget to ask how rare the predicted outcome actually is. And the less common an event is, the harder it is to forecast reliably.
Earthquake predictions, for example, have shown themselves to be essentially useless. So you should ignore farfetched market calls (like “Dow 36,000” or “The Great Depression of 1990”); it doesn’t pay to take them seriously. “You should always bear in mind the basic likeliness of the event being predicted,” says Matthews, “and see if the forecaster’s track record shows any sign of validity.”
Even your apparent tendency to pick the wrong checkout line holds an investing lesson. If just three cash registers are open, the odds that you’ll pick the fastest line are only 33%. Two-thirds of the time, on average, one of the other lines will end up moving faster. With four lines open, your odds drop to one in four.
So (assuming the checkout clerks are equally efficient), the raw math is always against you; no matter which line you pick, it will usually be the wrong choice. You may think your success rate is a function of how well you size up lines — but in fact it’s predetermined.
Investing is much the same. The odds that any given stock or fund will do better than the market are fifty-fifty — before you pay brokerage commissions, fees or taxes. It’s not within your power to change those odds.
So instead of expending all your energy trying to find the long-shot investments that might deliver way-above-average returns, you should focus on doing things that are well within your power to achieve: maintaining a diversified portfolio, avoiding short-term trading and minimizing your costs and taxes.
“The reason things go wrong is because they really can,” says Matthews. “It’s not just you and it’s not just your perception. The universe is made that way, so get over it.” The best way to get over Murphy’s Law is to get around it. Smart investors remember that controlling the things they can control is the only way to ensure that whatever should go right will go right.
* Or whichever lane we pick to drive in on the highway. That, too, is a cognitive illusion.