Finding patterns where there are none: Investing based on patterns

Let's play a few rounds of roulette. Which outcome is more likely?

Red | Red | Red | Red | Red | Red | Red | Red

Red | Black | Black | Red | Black | Red | Red | Black

The first outcome seems rigged. Intuitively, the second outcome seems more likely because it looks more random and exhibits less of a pattern. But in reality, both outcomes are equally likely. Each roulette spin is independent, and on each spin you have a 47.4% chance of hitting red or black. The outcome of each spin is not influenced by the previous spin, and cannot affect the upcoming spin in any way. The belief that if something happens more frequently than normal during a given period, it will happen less frequently in the future is called the gambler's fallacy.

We humans are wired to find patterns, even when they don't exist. It's why people see faces in nature, religious figures on toast and come up with conspiracy theories (read Scientific American for more on Patternicity). When Apple first launched the iPod shuffle, people complained that the 'random shuffle' wasn't random enough because they would sometimes hear the same song twice. The truth was, Apple did too good of a job in making it truly random, which meant that it didn't take into consideration whether a song had been played recently. They had to later change their algorithm to be less random to seem more random.

We also tend to make investment decisions based on seeing historical patterns and trends that may amount to little more than random chance. We love to draw price charts and find 'Head and Shoulders', 'Double Bottom', or 'Triangle' patterns, then predict where prices will go. But this is largely an exercise in futility. British mathematician and philosopher Frank P. Ramsey proved that randomness will always exhibit some patterns, no matter how complicated you make a system. Basically, he showed that given enough variables to play around with, you can find any pattern you want.

We try to find rhyme and reason in everything.

Things happen and we look for an explanation, finding meaningful patterns in meaningless noise. It is important to ignore the noise, stay disciplined in following time-tested, empirically-proven investment plans, rather than be swayed by your human condition.