When Does Common Sense Enter The Investment Picture?

Early humans needed pattern recognition and motion detection to survive.

Humans are immensely capable pattern finders. The skill arose tens of thousands of years ago. Our forebears would not have existed long if the could not distinguish a tiger from long grass. The patterns of the seasons helped them become farmers.

People are especially good at detecting motion. Maybe owls and falcons are better, but there are not many other animals that are.

How does that become a problem?

Any skill can become a problem if it is misapplied.

Notice that sight is a two-part system. Motion is the cue. The eye captures the information and the brain processes it. The eye is indifferent to what it sees, so the brain alone is the problem.

When the brain is fed moving information it creates a pattern even when there is none.

If you believe in patterns, the stock market is like a bus

That is the theory behind momentum investing. You see something moving, you get on. When it stops you get off. The implicit assumption is that things that correlate have a cause. Something causes motion.

That’s the basis of and the reason for pattern making. Patterns are just long correlations. And, they are misleading.

Correlations confuse us

I have written about correlation and causation before.

Correlation is not causation and We are all gullible

If correlation always showed causation, all would be well. But it does not. The near perfect correlation of divorces in Maine and the US national consumption of margarine might have a cause, but it is obscure.

Similarly, why the number of lawyers in Ohio is moderately correlated with banana prices and very strongly negatively correlated with per capita consumption of high fructose corn syrup might cause you to scratch your head.

When we see patterns that are not real

We act on evidence. Patterns are evidence until they aren’t. When we act on spurious patterns we tend to be wrong. “Knowing” something that is wrong is worse than knowing nothing. When you know nothing, you can still be right by accident.

How “Buy and Hold” works.

Motion in the stock market is not the same thing as a lurking tiger.

Buy and hold is a commons sense decision because it isolates your thinking from the random patterns  found in the stock market auction pricing system. It makes you focus on the business value arising from strong management and well executed transactions.

Stock prices are mostly just statistical noise, but if look closely enough you can find patterns in the noise. That leads to error.

Looking closely triggers the problem, so don’t do it.

Daniel Kahneman, one of the minds behind behavioural economics, is quite clear about this.

“If owning stocks is a long-term project for you, following their changes constantly is a very, very bad idea.”

Spurious patterns are generated by looking too often.

One step in lifetime financial success is the common sense idea of avoiding, “very, very bad ideas”

Try it.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  don@moneyfyi.com  866-285-7772

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