Nick Stewart says patterns are a fallacy when the only thing you can truly rely on is the randomness of returns.
OPINION
Humans are exceptionally good at recognising patterns.
It’s an involuntary skill we have picked up through millennia of evolution – the ability to recognise what was good or bad last time, and act accordingly in the future.
Unfortunately, there is not much call for it when it comes to investment. Patterns are a fallacy when the only thing you can truly rely on is the randomness of returns. A few examples:
The 22nd most successful money manager at the time in the USA was a Wall Street sensation – Raven, a chimpanzee who chose her stocks by throwing darts at a list of internet companies.
In 1999 she delivered a 213 per cent gain and outperformed over 6000 Wall Street brokers, much to the delight of the general public.
Quite deservedly, she still holds the Guinness World Record as the ‘Most successful chimpanzee on Wall Street’. She even had her own dedicated website to monitor her picks called MonkeyDex.
Raven eventually went bankrupt from her picks – partially due to the dot-com bubble bursting. More importantly, every single stock Raven picked is worth nothing today. The firms have all either collapsed or otherwise fallen from grace.
Perhaps if they’d allowed Raven to pick from a more diverse pool rather than one industry, she could have demonstrated true randomness better.
Dr David J. Leinweber of Caltech has some fantastic research aptly named; ‘Stupid Data Miner Tricks: Overfitting the S&P 500′.
He focuses on data mining and how it can be selectively used to create a pattern and explain so-called ‘reasons’ why the stock market moves up or down.
One set of data he used to show just how easy it is to find arbitrary correlations by data mining was butter production in Bangladesh.
Then, he went a step further and tied in cheese production in Bangladesh and the US. He added another variable – sheep population in those countries. These three variables predicted 99 per cent of the market’s movement in the time period studied.
Leinweber himself puts it best: “It is utterly useless for anything outside the fitted period… Just a chance association, which would inevitably show up if you looked at enough data series. Pretty much anything would have worked, but we like sheep.”
This is an entertaining one – every time American rapper Lil Yachty drops a record, the stock market crashes.
Redditors deep in the lore have tracked this apparent correlation back to his mixtapes in 2015, which was not a great year for the S&P 500.
Of course, by now the Lil Yachty theory has basically disproven itself as the S&P 500 rose a little bit following his fourth studio album earlier just this year.
Time will always prove these patterns wrong, no matter how fun they are to speculate on. Pattern recognition works until it doesn’t, and it tends to go wrong very quickly.
Much like your grandparent, who always bought Lotto with the grandchildren’s birthdays as the ‘winning’ numbers, trying to assign a pattern to stock returns would only work by pure chance.
Here’s what actually works: Time, patience, and sticking to your financial plan (provided it’s a sound one).
Every year we send our clients an up-to-date graphic showing the randomness of returns in a set range of New Zealand, Australian and global assets. It goes back 10 years and shows there is truly no rhyme or reason to the movement of specific assets.
We like to show this information because it is the easiest way to illustrate why you should avoid patterns. What was up last year may be up again this year, but it may also have fallen spectacularly.
Any investment portfolios you have should be broadly and globally diversified across countries, industries and asset classes. You should not be picking stocks based on anything, but rather creating a strategy where if one area of the portfolio dips, another may rise.
So yes, patterns may have worked for our ancestors when remembering which berries were good to eat… but when it comes to financial matters, past returns are in no way an indication of future performance.
Your trusted, local financial adviser will know that, and know how to create a plan that uses randomness to your long-term advantage. Calling them for a face-to-face chat about your situation and goals is a great place to start.
It’s better than counting sheep in Bangladesh, at any rate.
· Nick Stewart (Ngāi Tahu, Ngāti Huirapa, Ngāti Māmoe, Ngāti Waitaha) is a Financial Adviser and CEO at Stewart Group, a Hawke’s Bay-based CEFEX & BCorp certified financial planning and advisory firm. Stewart Group provides personal fiduciary services, Wealth Management, Risk Insurance & KiwiSaver scheme solutions. Article no. 354.
· The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from a Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961 or visit our website, www.stewartgroup.co.nz