In Thinking, Fast and Slow we learn that we have two systems of thinking. System 1, a quick thinking system built on heuristics and patterns. System 2, which is our deeper thinking rational system.
Because system 1 has to be quick it sees patterns when they aren’t there. As The Psy-Fi Blog explains.
The reason our pattern matching systems go wrong isn’t hard to figure out. In evolutionary terms the downside of missing something which is there – like a snake – is far higher than the downside of seeing something which isn’t. Reacting to 99 fake snakes is fine as long as you also react to the one real one. By and large it’s better to have a system that’s overly sensitive and makes mistakes than one that’s unresponsive to potential threats.
So seeing patterns where there aren’t any isn’t surprising. However, when you attach this tendency to a brain that’s evolved to seek meaning and explanations for everything, even where events are completely random, you get all sorts of unexpected consequences, like superstitious behavior, religious beliefs and stock market crashes.
Technical analysis is all about pattern recognition. But as the Psy-Fi blog goes on to point out through the research paper Noise Trading and Illusory Correlations in U.S. Equity Markets that the most popular chart patterns are just noise. They provide no real value. But humans are pattern seekers. We look for clues and patterns in the randomness.
Worse Than Rats & Pigeons
Jason Zweig points this out in his book Your Money & Your Brain. An experiment pits people against rats and pigeons. In the experiment, two lights could be flashed; one green the other red. The red light flashes 20% of the time. The green light flashes 80% of the time. The order of the flashing is completely random and the human test subjects are told this. The object of the experiment is to guess which colored light will flash next.
The optimal strategy is to guess green every time. You will be right 80% of the time. Rats and pigeons learn quickly to select green all the time. People, not so much. People still try to guess when the red light will flash. On average people guess green 4/5 times and red 1/5 times. Trying to guess when the red light will flash drops people’s accuracy down to 68%. People also tend to get worse at guessing the longer they play.
Unlike other animals, humans believe we’re smart enough to forecast the future even when we been explicitly told that it is unpredictable. In a profound evolutionary paradox, it’s precisely our higher intelligence that leads us to score lower on this kind of task than rats and pigeons. – Jason Zweig, Your Money & Your Brain
Play the Odds
The rats and pigeons learned to use the odds to their favor. They’ll guess wrong many times but in the long run, they learn to maximize their rewards by guessing green all the time. A similar situation pops up with investing.
People spend an extraordinary amount of time trying to guess the day-to-day fluctuations of individual stocks and indices. It is why triple leverage ETFs are able to exist. Guessing the day-to-day moves is close to a 50/50 bet. It is when you start looking at longer-term returns that the odds tilt heavily in your favor.
This is the pattern that individual investors should be seeing. It is the 80% green light. All that extra effort trying to guess daily, monthly, or yearly moves is the same as trying to guess when the red light will flash. It will only diminish your ability to maximize your long-term rewards.