We are pattern-seeking, story-telling animals. – Edward E. Leamer*
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 anything random, you will search for patterns within it. It’s how your brain is built.
It is uncontrollable. You can’t turn this kind of processing off or make it go away.
That is in part why charts hold such sway with investors and traders alike. We are not necessarily focusing on technical analysis, per se, but simply visual presentations of data. As with statistics, with enough effort one can get a chart to say pretty much anything. However even charts that are produced in good faith can still mislead us.
That is why we as investors and traders need to be constantly on alert to situations where our brains can fool us into thinking we can foresee the future. There has been a very popular chart (from Doug Short at dshort.com**) floating around the blogosphere during the past year that depicts graphically four (including the most recent) bear markets. Although it has been reproduced any number of times we present it below for the sake of convenience:
A quick look at the chart shows how one might have instinctively reacted during three distinct phases to the latest bear market. Prior to October 2008 one would have come away from the chart thinking we were in the midst of a run of the mill bad bear market. A few months later one could not help coming away from the chart thinking that the 2008-2009 bear market was tracking with 1929 (and the subsequent disastrous results). Today the chart would seem to indicate that the worst has past and that a bull market is now firmly in place.
Short wisely notes on the site that: “These charts are not intended as a forecast but rather as a way to study the current decline in relation to three familiar bears from history.” However that does not prevent our primitive brains from doing exactly that.
One blogger Eddy Elfeinbein at Crossing Wall Street thinks we should stop looking at these charts altogether. Elfeinbein writes:
Starting today, I refuse to look at any more charts that contain five or more squiggly lines, one labeled 2009, another labeled 1929, another 1974, another 1379. Enough!
These charts were kind of fun to look at a few months ago, but seriously, markets don’t trace out precise patterns from decades ago…Once you start toying around with the data, you can make anything fit.
The problem for Eddy and everyone else is that these charts are not going away any time soon. As we have seen, even if a chart is produced correctly it can still induce us to generate implicit forecasts where none are really warranted. Unfortunately none of us are immune from this pattern seeking run amok. It is a part of what makes us human. However being forewarned is forearmed. Now when it comes to charts you know what to look out for (or avoid altogether).
*Quote from Edward E. Leamer, Macroeconomic Patterns and Stories: A Guide for MBAs, Springer-Verlag, 2009, p.3, via an alert reader.
**If you have not checked out dshort.com we would recommend a visit. In addition to the Four Bad Bears chart he has a number of other interesting charts and articles that are worth a look.