Patternicity: Investor Behaviour and Pattern Seeking

Topic: Investments

Fergus W. Gould CFA

December 10, 2015

Creative Commons photo courtesy of Lucapost


Print & Share

Print

Patternicity: Investor Behaviour and Pattern Seeking

You have heard the stories. An image of the Virgin Mary can be seen on the side of a grain silo! Trenches have been spotted on Mars! Maybe you were told not to go near the old McLean house on the night of a full moon.

When seeing is believing

What is this all about and how can it possibly be relevant to investing? It turns out that humans are hard-wired to seek patterns. The above – visual images, beliefs and superstitions – are typical, and investors experience it all the time. Seeing patterns helps investors feel that they have created order out of chaos. Due to pattern seeking, investors tend to jump on top-down themes and trends. So, if oil inventories are growing and the oil price is down, now must be a good time to sell oil company stocks, right? These patterns can be insightful, but they can also lead investors astray. We humans seek and find patterns…frequently even when no pattern exists. We think we understand the cause and effect of many things, but in many cases we are wrong. This error – seeing a pattern where none in fact exists, or in other words, the tendency to see meaning in meaningless noise – has been dubbed patternicity.1

Grunt and go on

There is an explanation for all of this and it derives from evolution. Human beings are genetically wired to see patterns. Ancient man depended on pattern identification to sense danger, to eat and to procreate. If leaves rustled in the jungle, it could be a predator or it could be the wind. Better to identify it as a predator and evade it, not become tiger dinner!

Scientists know pattern recognition errors occur. People routinely make errors in cognition – sometimes identifying a pattern that is not there and sometimes not discerning a pattern that is there. If you have a vague recollection of any of your scientific or statistical endeavours from high school or university, you may recall the first as a Type I error (a false positive) and the second as a Type II error (a false negative). Thankfully, we humans are not totally useless – we also get lots of things right (correctly perceiving patterns that are there and not seeing ones that don’t exist). These four combinations of reality and perception are illustrated in the matrix below.

Matrix Orig

To minimize Type I and II errors, scientists ensure rigour in their experiments and subject their findings to the self-correcting process of peer review, independent verification and replication. Statisticians add probabilistic rigour by increasing the sample size to reduce these errors.

So far, so good. But how does this relate to evolution and the average Joe?

Let’s go back to the jungle. In our example with the tiger, not sensing the tiger is a Type II error… and very costly. Sensing a tiger when none was in fact there, a Type I error, was far less costly… the only consequence being that your ancient ancestor received a rush of adrenaline, grabbed a weapon, and lived to tell the tale. Surely, over eons, humans would have evolved through natural selection to reduce both types of errors? If so, why are false patterns as prevalent as they are?

So here is the thinking. We evolved by natural selection through a process known as association learning – developing and honing our brains’ “pattern-recognition engine” to connect the dots and identify the pattern. To aid in survival and reproduction, we learned instinctively to reduce Type II errors. Unfortunately, discerning non-obvious patterns is all about probabilities and conditional probabilities, and we humans are terrible at probabilities. So the evolutionary process that succeeded in reducing Type II errors came at the expense of making more Type I errors (sensing patterns that are actually not there). It makes sense that we learned to avoid the costly errors, but the less costly errors weren’t that important and didn’t get reduced by natural selection. In the exhibit below we illustrate how evolution adjusted the matrix.

Evolution Matrix

To reduce the Type II errors, the evolution of our pattern-recognition engine has moved the entire horizontal dividing line upwards – fewer costly Type II errors, but more Type I errors. In 2008 a pair of researchers from Harvard and the University of Helsinki2 tested this theory using evolutionary modelling to demonstrate that when the cost of believing a false pattern is real is less than the cost of not believing a real pattern, natural selection will favour patternicity (an increase in Type I errors ).  This is also evidenced in nature. As an example, predators only avoid nonpoisonous snakes that mimic a poisonous species in areas where the poisonous species is common.

So what’s an investor to do?

In short, people, investors included, naturally seek and find patterns, frequently when none exist. For investors, the probabilistic component in pattern identification is exacerbated by other, ahem… behavioural faults. Namely, investors are inherently driven by the dual emotions of fear and greed. Whenever one emotion predominates, an investor’s assessment of the probabilities, poor at best, is further skewed. Needless to say, this is problematic and leads to losses.

At Nexus, we think that there are ways to control these errors. We recognize that we don’t know everything.  So we make more, reasoned investments, rather than fewer, bigger “bets”. We believe in a detailed, fundamental bottom-up investment process to pick each stock, rather than a potentially more blunt top-down approach. We endeavour to remain a skeptic and be on the look-out for new data that “changes the pattern”.  A team investment decision can reduce emotion and errors relative to an individual decision. This takes more time. But in stock picking it’s better to be slightly late and right than early and wrong.

1.Much of this article is derived from Michael Shermer’s article “Patternicity: Finding Meaningful Patterns in Meaningless Noise”, published in Scientific American, December 2008.

2.Kevin Foster and Hanna Kokko, The Evolution of Superstitious and Superstition-like Behaviour, Proceedings of the Royal Society B, September, 2008.

More Like This...

See another CRM2 blog post that may be of interest to you.

CRM2: The Nexus Approach to our CRM2 Reports

Topic:
CRM2
Excerpt:
With changing securities regulations coming into effect, investment firms are now required to provide individual investors with specific additional in

More Like This...

See another Foundations & Endowments blog post that may be of interest to you.

Donor Advised Funds: An Overview

Topic:
Foundations & Endowments
Excerpt:
As we approach the end of the calendar year, taxes and charitable giving inevitably surface as ”things to do” in peoples’ minds. Here, we’d like to

More Like This...

See another Human Interest blog post that may be of interest to you.

COVID: An Uneven – and Unequal – Recovery

Topic:
Human Interest
Excerpt:
Canadians have had enough of the lockdown. Here we are 18 months after you first heard of the then mysterious Wuhan flu. Today, but for any curve ball

More Like This...

See another Inside Nexus blog post that may be of interest to you.

Walking Through Time: The History of Nexus

Topic:
Inside Nexus
Excerpt:
Bob Topp’s death last month triggered my memory “replay” button, likely as it did for many of us, whether as a long-time Nexus client, employee, or

More Like This...

See another Investments blog post that may be of interest to you.

Q&A From Our Quarterly Investment Review

Topic:
Investments
Excerpt:
Your Nexus investment team participates in many meetings where a company’s CEO or CFO presents to a group of investors. These meetings often have a

More Like This...

See another Pearls of Wisdom blog post that may be of interest to you.

“Work, Work, Work, Work, Work, Work”

Topic:
Pearls of Wisdom
Excerpt:
This has been a busy year. I’ve had lots happening on the home front (a wedding!) and lots going on at the office (too long to list!) Managing work

More Like This...

See another Tax Planning blog post that may be of interest to you.

The Great Transition – A Tax Efficient Withdrawal Strategy

Topic:
Tax Planning
Excerpt:
The change from “saver” to “spender” is what I call the great retirement transition. Figuring out how to draw on your retirement savings to meet your

More Like This...

See another Wealth Planning blog post that may be of interest to you.

Living to 100… Is 100 the New 80?

Topic:
Wealth Planning
Excerpt:
It’s a common saying that there are two certainties in life, death and taxes. While we have a pretty good idea when we get taxed, which feels like all

On a Side Note…

See another CRM2 Nexus Notes Quarterly article that may be of interest to you.

No posts found.

On a Side Note…

See another Foundations & Endowments Nexus Notes Quarterly article that may be of interest to you.

Donor Advised Funds: An Overview

Topic:
Foundations & Endowments
Excerpt:
As we approach the end of the calendar year, taxes and charitable giving inevitably surface as ”things to do” in peoples’ minds. Here, we’d like to

On a Side Note…

See another Human Interest Nexus Notes Quarterly article that may be of interest to you.

COVID: An Uneven – and Unequal – Recovery

Topic:
Human Interest
Excerpt:
Canadians have had enough of the lockdown. Here we are 18 months after you first heard of the then mysterious Wuhan flu. Today, but for any curve ball

On a Side Note…

See another Inside Nexus Nexus Notes Quarterly article that may be of interest to you.

Walking Through Time: The History of Nexus

Topic:
Inside Nexus
Excerpt:
Bob Topp’s death last month triggered my memory “replay” button, likely as it did for many of us, whether as a long-time Nexus client, employee, or

On a Side Note…

See another Investments Nexus Notes Quarterly article that may be of interest to you.

The Future of Money: a Digital Currency Primer

Topic:
Investments
Excerpt:
As a bottom-up investment management firm, we spend a lot of time looking at specific companies. But keeping an eye on evolving industry trends can be

On a Side Note…

See another Pearls of Wisdom Nexus Notes Quarterly article that may be of interest to you.

A Table for None, Please; Working From Home on the Rise

Topic:
Pearls of Wisdom
Excerpt:
Reading is one of the principal occupations in our profession. As we digest a wide range of material, interesting ideas and surprising facts – some

On a Side Note…

See another Tax Planning Nexus Notes Quarterly article that may be of interest to you.

The Great Transition – A Tax Efficient Withdrawal Strategy

Topic:
Tax Planning
Excerpt:
The change from “saver” to “spender” is what I call the great retirement transition. Figuring out how to draw on your retirement savings to meet your

On a Side Note…

See another Wealth Planning Nexus Notes Quarterly article that may be of interest to you.

Living to 100… Is 100 the New 80?

Topic:
Wealth Planning
Excerpt:
It’s a common saying that there are two certainties in life, death and taxes. While we have a pretty good idea when we get taxed, which feels like all