The Financial Fallacy of Patterns, Causation & Correlation

"Nobody goes there anymore.  It's too crowded." ~ Yogi Berra

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!

Comments

[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