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Interesting article with strong application to technical trading...
JW
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http://www.money.com/money/depts/investing/fundamentalist/archive/0011
.html
November, 2000
The trouble with humans
Why rats and pigeons might make better investors than people do.
By Jason Zweig
• The man with two brains
• The dance of happenstance
• Mind over matter
Humans have a remarkable ability to detect patterns. That's helped
our species survive, enabling us to plant crops at the right time of
year and evade wild animals. But when it comes to investing, this
incessant search for patterns causes more heartache than anything
else.
We see that value funds have stunk for years, so we dump them and
pile into fashionable growth stocks like Intel and Cisco--right
before they hit the skids.We buy a stock because some guy at a
barbecue recommended it, and everything he talks about seems to go up-
-but this one plunges. We put every dime in stocks after hearing that
they've trounced bonds forever--only to see bonds zoom past stocks
this year.
Our incorrigible search for patterns leads us to assume that order
exists where it often doesn't. Many of us believe, for example, that
it's possible to foresee where the market is heading or whether a
particular stock will continue to rise. In reality, these things are
far more random and unpredictable than we like to admit.
Remarkably, scientists are now finding that this tendency to look for
patterns is hardwired into the human brain. Psychologists have long
known that if rats or pigeons knew what the Nasdaq is, they might be
better investors than most humans are. That's because, in some ways,
animals are better than people at predicting random events. If, for
instance, you set up two lights in a laboratory and flash them in a
random sequence, humans will persistently try to predict which of the
two lights will flash next. Stranger still, they'll keep trying even
when you tell them that the flashing of the lights is purely random.
Let's say you flash a green light 80% of the time and a red one 20%
of the time but keep the exact sequences random. (A run of 20 flashes
could look something like this: GGGGRGGGGGGGRRGGGGGR.) In guessing
which light will flash next, the best strategy is simply to predict
green every time, since you stand an 80% chance of being right.
That's what rats or pigeons generally do in a similar experiment that
rewards them with a crumb of food whenever they correctly guess the
next outcome.
But humans are apparently convinced that they're smart enough to
predict each upcoming result even in a process they've been told is
random. On average, this misguided confidence leads people to get the
right answer in this experiment on only 68% of their tries. In other
words, it's precisely our higher intelligence that leads us to score
lower on this kind of task than rats and pigeons do.
The man with two brains
A team of researchers at Dartmouth College, led by psychology
professor George Wolford, has been studying why it is that we think
we can predict the unpredictable. Wolford's team 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 epilepsy. Here's the group's key
discovery, which was recently published in the Journal of
Neuroscience: 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.
Wolford's conclusion: "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, even when none exist." His research
partner, Michael Gazzaniga, has christened 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 adds, "a constant search for
explanations and patterns in random or complex data is not a good
thing."
The dance of happenstance
Trouble is, the financial markets are almost--though not quite--as
random as those flashing lights. On CNBC and countless websites,
investment strategists and other so-called experts scan the momentary
twitches of the market and predict what will happen next. Far more
often than they're right, they're wrong--and the Dartmouth discovery
about the interpreter in our brains helps explain why. These pundits
are examining a chaotic storm of data and refusing to concede that
they can't understand it. Instead, their interpreters drive them to
believe they've identified patterns upon which they can base
predictions about the future.
Meanwhile, the interpreters in our own brains impel us to take these
seers more seriously than their track records deserve. As Berkeley
economist Matthew Rabin has pointed out, just a couple of accurate
predictions on CNBC can make an analyst seem like an ace, because
viewers have no way to sample the analyst's entire (and probably
mediocre) forecasting record. In the absence of a full sample, our
interpreters take over and lead us to see the analyst's latest calls
as part of a pattern of success.
The interpreter also helps explain what's called the gambler's
fallacy--the belief that if, say, a coin has come up heads several
times, then it's "due" to come up tails. (In fact, the odds that a
coin will turn up tails are always 50%, no matter how many times in a
row it's come up heads.) The gambler's fallacy is as common on Wall
Street as hairballs under a couch: Some pundits will say emerging
markets are sure to rebound because they've been doing badly for
years, while others say tech stocks will crash because they've risen
so much. In reality, the market makes mincemeat out of most of our
predictions; apparent trends often foretell little about the future.
In its constant search for patterns, the interpreter also tricks
investors into believing that hot performance streaks are sure to
persist. Based on a few months of scorching returns, investors piled
into Internet stocks late last year--and are now sitting on returns
as cold as liquid nitrogen. What's happening here is simple: As soon
as a pattern seems to emerge in the market, the interpreter in our
brains sees it as part of a predictable trend--rather than a random
happenstance that may never be repeated.
Finally, I think the Dartmouth research helps solve another puzzle.
Even when we have only a small sample of our own performance at risky
tasks--a few yanks on a one-armed bandit or a handful of big scores
on tech stocks--we tend to decide either that we know what we're
doing or that we're on a lucky streak. We almost never conclude that
our success is the result of chance alone. Dutch psychologists Willem
Wagenaar and Gideon Keren have found that professional gamblers, when
accounting for their wins and losses, greatly overestimate the role
of skill, attributing just 18% of the outcome of each bet to random
chance.
Similarly, when a day-trader makes a fat profit off a stock after
doing no research and owning it for only seconds, he's likely to
conclude that he's an analytical genius or has an uncanny feel for
the market. In truth, that profit is probably an accident--but his
mind won't allow him to see things that way.
Mind over matter
So how can you keep your brain from giving you a garbled view of the
investment world? You could disable your interpreter once and for all
by having a neurosurgeon separate your brain's two hemispheres, and
then by scrutinizing investment information in the leftmost part of
your field of vision. That way, only the right half of your brain
would be able to process investment data, and the interpreter would
be shut down. However, it won't be easy talking a surgeon into
carving your cranium open for this, and watching CNBC out of the far
corner of your eye might be a pain. So here are some less drastic
options.
Don't obsess. In one of his most startling findings, George Wolford
of Dartmouth says people in his experiments earned higher scores when
they were distracted with a "secondary task" like trying to recall a
series of numbers they'd recently seen. In other words, interruptions
improved their performance by preventing the interpreter in their
brains from seeking spurious patterns in the data. Likewise,
continually monitoring your results will probably make them worse--as
you fool yourself into seeing trends that aren't there and trade too
much as a result. If you're spending more than a few hours a month on
investing, you're not only taking valuable time away from the rest of
your life, but you're almost certainly hurting your returns.
Remember what's at stake. John Staddon, a professor of psychology at
Duke, says rats or pigeons will generally bet on the option that has
had the highest probability of success over time. But, notes
Staddon, "humans will consistently do that only when the stakes are
large and the consequences really matter." So you'll make better
financial decisions if you convince yourself that there's no such
thing as a small or casual investment. Just think of the thousands of
dollars you could squander--and the blissful retirement you could
jeopardize--with a few careless stock picks.
Track your forecasts. Whenever you've got a strong opinion about
where a stock, or the market, is headed, jot it down and note the
date. This will keep you from conveniently forgetting your failed
forecasts and may provide you with a humbling reminder of your
limitations as a soothsayer. And whenever some analyst seems to know
what he's talking about, remember that pigs will fly before he'll
ever release a full list of his past forecasts, including the
bloopers.
Defy the chaos. Not everything about investing is chaotic, however; a
few things really are predictable. On average, over time, investors
who keep costs low (either through index funds or buy-and-hold stock
portfolios) are mathematically certain to outperform in- vestors who
trade too frequently or buy funds with high expenses. So before you
focus on your returns--which are entirely unpredictable--make sure
that your investments are not overpriced.
Diversification is another principle that defies chaos. Consider the
danger of investing almost exclusively in tech stocks. Many investors
who bet heavily on the sector in 1982--the last time it was this hot--
loaded up on market darlings such as Alpha Microsystems, Commodore,
Tandy, Vector Graphic and Wang Laboratories, which later tanked. If
you diversify--by owning a wide range of U.S. and foreign stocks and
bonds--you virtually eliminate the chance that a few duds like these
will ruin your financial future. Broad diversification is still the
best insurance against the risk of making an investment mistake. And
there's nothing random about that.
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