The Search for Stock Market Patterns

It’s tough to identify the one mistake that is the worst or most common investors make. But my vote is the desire to identify patterns in the markets and use those to develop rules of investing. There are a few people who do this successfully. But they have very elaborate rules that take many factors into account. They also recognize that even their elaborate models are wrong at least a third of the time. So part of their approach is to cut losses quickly. Otherwise, the quest for one or two simple rules to guide our decisions is misguided. There’s a lot of research now that establishes people are programmed to seek patterns in random data and often are led astray by this quest. They often confuse a correlation with causation or see a pattern in short-term data that isn’t justified by longer-term data. Or they simply see a pattern where there really isn’t one. I give some details about these mistakes in my book, Invest Like a Fox…Not Like a Hedgehog.

The mistake isn’t restricted to investing and finance. Recently I stumbled upon a similar argument in the book The Inner Game of Golf by Timothy Gallwey. The book is about how to think, or not think, while playing golf and not about technical golfing ability. It was quite the rage at one time, as was its predecessor, The Inner Game of Tennis. It isn’t as widely-discussed now, because most instructors and coaches use its basic teaching as though it’s generic information. Here’s the passage:

It seems as if our appetite for formulas in golf and in life is as unending as the cycle of hope and disappointment that these illusory mental constructs engender. We want encapsulated wisdom. We want to read the formula in a book and apply it to our lives. We don’t particularly want to think about the formula: it’s enough to know that someone who calls himself an expert has thought about it. Our job is simply to follow it. A formula is a mental construct that tells you what to do in a given situation. In the face of uncertainty, the formula gives direction and certainty. If golf really worked that way, we would all be scratch golfers by now. And if life worked that way, we would all have happy lives.

My passion to transcend formulas does not come from a life free of them. Precisely the opposite—I was brought up with formulas for everything. Being Irish, I also had a bit of the rebel in me, so I turned against traditional formulas only to come up with untraditional (but equally problematic) formulas. Finally, I’ve arrived at the point where I’m ready to give up on formulas once and for all, except as they apply to routine maters like filing a tax return or installing a piece of software. As noted in Chapter 6, “Discovering Technique,” I still believe that it is important to understand the technology of anything you want to do excellently. But understanding and following formulas are two different things. I don’t hit the ball with my understanding. My understanding contributes, in the background, to my execution. But in the execution itself, I am either following formula or following feeling. I am either coming from the mind or from the gut.