Pattern seeking run amok

From Abnormal Returns:

We are pattern-seeking, story-telling animals. – Edward E. Leamer*

We human beings are pattern seekers. We can’t help it. We see patterns even where none exist. As Jason Zweig in his book Money & Your Brain (via IndexUniverse) writes:

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....MORE