What will the stock market do tomorrow?

Image: Reuters/Brendan McDermid
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You probably found this article because you searched online for some variation of the headline. That’s not a bad place to start, so good job. A basic Google search offers about as much insight into the stock market’s future movements as supposedly sophisticated number crunching.

The thing is, if I knew the answer to the question in the headline, I wouldn’t make my living as a journalist. Such clairvoyance would make me very rich indeed.

If you are looking to make money in the markets, you should familiarize yourself with what economists call the efficient market hypothesis. Although there are plenty of ways to judge whether stocks seem under- or overvalued, this theory holds that prices always reflect all available information. Even if you think prices are “wrong,”  it is impossible to know when they will correct themselves and settle at “fair value.”

A lot of smart people try to time the market, but very few succeed. The vast majority of actively managed stock funds in the US can’t outperform benchmark indexes (paywall), despite professional managers with years of experience and the whizziest systems money can buy feeding them information. Over long periods of time, it generally pays to avoid the fees charged by fancy fund managers and simply park your money in cheap, broad-based index funds.

Let’s say, for argument’s sake, that you think stocks are overvalued and due for a fall. Even if you’re right, timing the correction is a fool’s errand. You can look for clues, though, in the prices of derivatives on stocks, which are based on how risky investors think the stock market will be in the future.

The VIX index tracks the implied volatility of the US stock market, based on S&P 500 options. This won’t tell you what the stock market will do tomorrow, but it can give you some indication of the range stocks are expected to move around in (both up and down). But remember that derivative traders don’t know that much more about the future than you do. Often, they base their expectations for volatility on the past, which is not always a good indicator of the future.

If you are hoping for higher returns over the long term, you should stick with index funds, but go for ones that are weighted toward riskier stocks, like small companies or firms in emerging markets. Generally, the riskier a stock is, the more you can expect it to grow over time. But this comes at a price: higher volatility means that there is also a greater chance that your portfolio will be worth less tomorrow than today.

Generally speaking, there is only one way to beat the market, and that’s take on more risk. If this makes you nervous, then the best advice is to invest in broad market index funds, fight the urge to trade, and get on with your life.