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November 12, 2009

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Leone

Great post Kent.
Perhaps the real problem is not with pattern recognition per se but human emotions that can blind one's path. Patterns (maybe rhythms is a more appropriate term) do exist. They are ubiquitous throughout nature, hardwired into our systems for survival.
We are part and parcel of a complex system and consequently fractal properties abound all around us, including in financial markets. It is a natural consequence to want to identify these patterns. However the term, as it's used in finance, has become quite perverse. In reality, we are unable to know in which part of the fractal we may find ourselves. Consequently, spotting a similar precedent does not preclude that it will result in a similar outcome. And as you say, the decision that one has to take is solely one of probabilities. The problem with pattern recognition is not so much the patterns but what I call the evils of human decision process; The gambler's fallacy (as you mentioned), confirmatory biases and recency bias. There are more of course but these, in my opinion, are the worst....
Thanks, Leonardo

Kent @ The Financial Philosopher

Outstanding comment, Leonardo! In fact, I think "comment" is too light of a term!

I agree that pattern recognition is not a problem in itself. It's finding patterns to confirm ill-conceived notions.

Perhaps you would agree that this form of confirmation bias is rooted in the human need and desire for control -- for safety, if you will? It's a form of self-illusion.

"If we choose, we can live in a world of comforting illusion." ~ Naom Chomsky

Dorian Wales @ The Personal Financier

Great post. The problem with patterns runs even deeper. Even if a pattern has been spotted it says nothing as to the related causality. Correlation is the bane of many of the social sciences, including economics. I've written quite a bit about it. Hume's brilliant analysis of the problem of induction is perhaps one my most favorite philosophical text as it leaves you shaken by the sheer truth of the arbitrariness of empiricist life. A fascinating subject.

Kent @ The Financial Philosopher

Thanks Dorian.

I need to go back to my philosophy texts and read more Hume!

The ancient philosophers, such as Socrates, or even eastern legends, such as Lau Tzu, believed humility to be the greatest of virtues.

As the prudent person gains more knowledge, they realize that there is much that they do not know.

"He who knows does not speak. He who speaks does not know." ~ Lau Tzu

Debt Consolidation Companies

Pattern recognition might be the root cause of most economic and market bubbles? Well, this is not really true, is it? It might indirectly involves with economic and market bubbles, but I personally won't consider it as the root causing these.

Good post. Thanks for sharing.

Kent @ The Financial Philosopher

DCC:

I believe there is a strong argument supporting pattern recognition as the root cause of economic and market bubbles.

Unfortunately, I'm not the one to scientifically make the case!

Intuitively, however, it is not difficult to draw a line from major financial institutions believing that personal incomes and home values would continue to rise indefinitely into the future (a pattern) to the financial collapse beginning in 2007. This is a form of pattern recognition that is fallacious, irrational behavior arising from false induction.

Think about the collective behaviors of home builders, consumers and individual investors. They saw no end to the money tap (easy money coming from home equity and loose lending practices).

On an anecdotal level, there are two unfinished homes on my street, both by the same builder who is now bankrupt. The builder was in business for 20 years and quite successful in my home town. Do you believe he didn't recognize a pattern of home values continuing to rise? Do you believe the banks would have provided financing if they did not believe the trend (pattern) of rising home values would end before the homes were completely built?

Of course, human emotions (complacency, greed, hubris) are all contributing factors but fallacious pattern recognition is the enabling factor for this irrationality.

That's just my unscientific opinion.

What do you think is the root cause of the current (or recent) financial crisis?

Thanks for provoking thought...

Kent & The Financial Philosopher

Marvin V

Your analogy regarding the coin toss is a great generalization on how the masses think. We often ignore the product itself, and persuade ourselves with an array of complexities that we are lead to becoming deficient.

I myself hope to become a Fund Manager one day who will use a more vivid but often ignored approach in investing. Although the fundamentals, and technicals can not be ignored because they are the mechanism's used by the masses and can provide an advantageous strategy. Understanding the correlations between many factors can deem profitable.

I am glad that I am exposed to such knowledge at a young age, and being a student in college I am more aware of the patterns that occur whether or not they're related to finance. Keep up the great work.

financial advisor

Great post We are part and parcel of a complex system and consequently fractal properties abound all around us. investment advisor knowleg is very important

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