Is last week's Yankees win a bullish indicator for stocks? Stock prices are at a 13-month high, does that mean that the market will continue to go up in the short-term? Or are stocks due for a correction? Do the answers to these questions really matter to your investment strategy?
Perhaps the greatest strength and simultaneous weakness of the human brain is its hard-wired tendency for pattern recognition. Certainly this heuristic wiring aided in pre-historic man's search for food and avoidance of danger but does it translate to prudent financial decisions? Not necessarily.
In fact, pattern recognition might be the root cause of most economic and market bubbles (and bursts), including those leading to the current financial crisis.
Those of you readers who are traders might counter my point by saying that momentum trading is real and can be quite foolish to ignore. Nothing attracts a crowd like a crowd! While this is true -- the crowd is "right" more often than it is "wrong" -- it also opens the door to peril -- to the confusion between causation and correlation and to the illusion of control.
"Death is caused by swallowing small amounts of saliva over a long period of time." ~ George Carlin
Humor, which I believe to be a form of philosophy, sure does have a way of illuminating the folly of human thought and behavior, doesn't it?
At root of searching for patterns and confusing causation with correlation is the philosophic term, fallacy, which is simply an instance of poor reasoning.
Perhaps the most common fallacy, with regard to investing, is the gambler's fallacy. For example, if a coin is tossed three times and it lands on heads each time, a large majority of people will detect a pattern and reason that the fourth toss will also be heads. Perhaps a smaller group might reason that it will land on tails, citing that the odds are against another toss landing on heads. Reasoning for both of these bets is fallacious because the chance of a coin landing on heads or tails is always 50%, regardless of the outcome (or number of) previous tosses.
With regard to investing, do Summer months cause stock prices to fall or is it just a period of time during most calendar years that is coincidental with weak stock market conditions? For example, the "sell in May and go away" phrase is based upon historical stock price movement (patterns) and suggests an investor avoid stocks from May through October. This year, however, the market, as measured by the S&P 500 jumped more than 18 percent from May 1 to November 1.
Of course, daily movement of the stock market is no toss of the coin and there are certainly times where technical analysis is more prudent than fundamental analysis. Furthermore, there is another counter-argument to be made, with investing and trading, that there is no real reason to distinguish between causation and correlation.
Essentially, the investor is looking for probability of an outcome. Regardless of how irrational the behavior may appear, all data must be considered because crowds often act irrationally. If the crowd anticipates higher stock prices because the Yankees win the world series, then this event may feed more of an illusion that conditions are favorable to buy stocks, thus becoming a self-fulfilling prophecy of sorts.
"Too keen an eye for pattern will find it anywhere." ~ T.L. Fine
In summary, and as with everything, there is a balance to be found but this balance is only accomplished through self-knowledge and self-awareness. To prevent a fallacious inference, one must be aware of the brain's tendency to find patterns; to take action on the pattern-based decision; and then to be given the illusion of control if the action is affirmed or "proves to be correct."
Put simply, do not be fooled by patterns! In fact, don't even look for patterns because you'll find one every time and everywhere you look!