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Thursday, 25 February 2016

Behavioral Bias 101: #1 Illusory Pattern Recognition

The Man In The Moon

Pareidolia’s that odd moment where you perceive a familiar pattern where none actually exists: it’s the man-in-the-moon, the elephant in the clouds, a religious figure in a pastry. Pareidolia is a specific form of pattern recognition; the human brain is hard-wired to see faces in things, presumably to ensure that babies attend more to other people rather than random bits of plastic.  More generally, though, pattern recognition is critical to human functioning, but has a nasty tendency to go wrong.
Snakes and Crashes

The reason our pattern matching systems go wrong isn’t hard to figure out. In evolutionary terms the downside of missing something which is there – like a snake – is far higher than the downside of seeing something which isn’t.  Reacting to 99 fake snakes is fine as long as you also react to the one real one.  By and large it’s better to have a system that’s overly sensitive and makes mistakes than one that's unresponsive to potential threats.

So seeing patterns where there aren’t any isn’t surprising. However, when you attach this tendency to a brain that’s evolved to seek meaning and explanations for everything, even where events are completely random, you get all sorts of unexpected consequences, like superstitious behavior, religious beliefs and stock market crashes.

Self-Control

In particular there’s some evidence (1) that suggests that people with weaker self-control are more likely to make these  illusory associations and, as poor self-control is associated with a wide range of unfortunate behaviors, it’s a leading indicator of someone who isn’t very good at making financial decisions. Or, indeed, almost any type of decision of any kind.

Just to add to this, the stress associated with uncertainty increases the level of illusory pattern recognition. So in situations where we aren’t in control and don’t know what’s happening, like the stockmarket, we’re more likely to see correlations where there aren’t any.  Gabriel Lepori (2) has demonstrated a link between eclipses and market downturns, and associates this with traders resorting to superstitious practices because of the pressures of uncertainty and lack of control.

There’s a clear read across from this to charts. Research shows (3) that popular chart formations are actually nothing more than noise, as illusory correlations from charts lead traders to compete with themselves. So trading volume increases and bid-ask spreads narrow: it's a self-fulfilling prophesy, not investment wisdom.

Know Yourself

As with so many of these biases, the main trick is to know yourself. If you’re basically superstitious you probably shouldn’t be an active investor. If you’re not then you still need to guard against such tendencies when markets go into one of their tailspins. And, perhaps, you could look for a few bargains the next time there’s an eclipse.

Links: lack of self-control, superstition, uncertainty

Research:
  1. Lacking Self Control Increases Illusory Pattern Recognition
  2. Dark Omens in the Sky: Do Superstitious Beliefs Affect Investment Decisions?    
  3. Noise Trading and Illusory Correlations in U.S. Equity Markets
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