Download - IndexUniverse.com

• It became a common belief, based on historical numbers,
that U.S. stocks tend to go up on Fridays and
down on Mondays—but, in the 1990s, they did the exact
opposite.
• October (the month of the 1987 market crash) is widely
supposed to be the worst month to own stocks—but,
over the long sweep of history, it has actually averaged
the fifth-best returns of any month.
• Millions of investors believe in technical analysis, which
supposedly predicts future prices on the basis of past
prices; and in market timing, which purports to enable
you to get out of stocks before they go down and back
in before they go up. There is little, if any, objective evidence
that either tactic works in the long run.
• Every year, many Wall Streeters root for National
Football Conference teams to win the Super Bowl, based
on the widely held—and wildly inaccurate—belief that
when teams originating in the old NFL take the championship,
the stock market goes up the next year.
What drives this behavior? For decades, psychologists
have demonstrated that if rats or pigeons knew what a stock
market is, they might be better investors than most humans
are. That’s because rodents and birds seem to stick within the
limits of their abilities to identify patterns, giving them what
amounts to a kind of natural humility in the face of random
events. People, however, are a different story.
In a typical experiment of this kind, researchers flash
two lights, one green and one red, onto a screen. Four out
of five times, it’s the green light that flashes; the other 20
percent of the time, the red light comes on. But the exact
sequence is kept random. (One run of 20 flashes might look
like this: RGRGGGGGRGGGGRGGGGGG. Another might be:
GGGGRGGGGGGGRRGGGGGR. You can view a simplified
version of this task at www.jasonzweig.com/uploads/matchvmax.ppt.)
In guessing which light will flash next, the best
strategy is simply to predict green every time, since you
stand an 80 percent chance of being right. And that’s what
rats or pigeons generally do when the experiments reward
them with a crumb of food for correctly guessing what color
the next flash of light will be.
Humans, however, tend to flunk this kind of experiment.
Instead of just picking green all the time and locking in an
80 percent chance of being right, people will typically pick
green four out of five times, quickly getting caught up in the
game of trying to call when the next red flash will come up.
On average, this misguided confidence leads people to pick
the next flash accurately on only 68 percent of their tries.
Stranger still, humans will persist in this behavior even when
the researchers tell them explicitly—as you cannot do with a
rat or pigeon—that the flashing of the lights is random. And,
while rodents and birds usually learn quite quickly how to
maximize their score, people often perform worse the longer
they try to figure it out. The more time they spend working
at it, the more convinced many people become that they
have finally discovered the trick to predicting the “pattern”
of these purely random flashes.
Unlike other animals, humans believe we’re smart enough to
forecast the future even when we have 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 do. (Remember that the next
time you’re tempted to call somebody a “birdbrain.”)
A team of researchers at Dartmouth College, led by psychology
professor George Wolford, has studied why we think we
can spot patterns where there are none. Wolford’s group ran
light-flashing experiments on “split-brain patients,” people in
whom the nerve connections between the hemispheres of the
brain have been surgically severed as a treatment for severe
epilepsy. When the epileptics viewed a series of flashes that
they could process only with the right side of their brains,
they gradually learned to guess the most frequent option all
the time, just as rats and pigeons do. But when the signals
were flashed to the left side of their brains, the epileptics
kept trying to forecast the exact sequence of flashes—sharply
lowering the overall accuracy of their predictions.
“There appears to be a module in the left hemisphere of
the brain that drives humans to search for patterns and to see
causal relationships,” says Wolford, “even when none exist.”
His research partner, Michael Gazzaniga, has nicknamed this
part of the brain “the interpreter.” Wolford explains: “The
interpreter drives us to believe that ‘I can figure this out.’
That may well be a good thing when there is a pattern to the
data and the pattern isn’t overly complicated.” However, he
warns, “a constant search for explanations and patterns in
random or complex data is not a good thing.”
That’s the investment understatement of the century. The
financial markets are almost—though not quite—as random
as those flashing lights, and they vary in incredibly complex
ways. Although no one has yet identified exactly where in the
brain the interpreter is located, its existence helps explain
why the “experts” keep trying to predict the unpredictable.
Facing a constant, chaotic storm of data, these pundits refuse
to admit that they can’t understand it. Instead, their interpreters
drive them to believe they’ve identified patterns from
which they can project the future.
Meanwhile, the rest of us take these seers more seriously
than their track records warrant, with results that are often
tragic. As Berkeley economist Matthew Rabin points out,
just a couple of accurate predictions on CNBC can make an
analyst seem like a genius, because viewers have no practical
way to sample the analyst’s entire (and probably mediocre)
forecasting record. In the absence of a full sample, a
small streak of random luck looks to us like part of a longer
pattern of reliable foresight. But listening to an “expert”
who made a couple of lucky calls is one of the surest ways
for an investor to get unlucky in a hurry.
It’s vital to recognize the basic realities of pattern recognition
in your investing brain:
• It leaps to conclusions. Two in a row of almost anything—rising
or falling stock prices, high or low mutual
fund returns—will make you expect a third.
• It is unconscious. Even if you think you are fully
engaged in some kind of sophisticated analysis, your
pattern-seeking machinery may well guide you to a
much more instinctive solution.
• It is automatic. Whenever you are confronted with
www.journalofindexes.com July/August 2008
13