Patterns are your friend…until they’re not

You come from work. You’re tired. You grab a handful of mini-pizzas and throw them in the microwave for a nutritious, 21^st-century dinner. When you open the microwave door, you expect to see hot, delightful mini-pizzas, which is what you’ve gotten every other time you microwaved mini-pizzas. Seems logical. It would be a bit strange if we put in mini-pizzas and took out boiled sheep brains instead.

Our brains have evolved to see patterns, anticipate them, and rely on them. Without such consistency, our worlds would more or less fall apart. We’d be completely overwhelmed by stimuli.  But this amazing processing ability, unfortunately, can sometimes tank our finances.

When we try to see patterns in situations where there simply are none (or where they are far more complex than our brains can handle), disaster may ensue. Just because the stock market is up one day, or ten, does not guarantee that it will continue to stay that way, but we tend to expect this. It’s not because we’re dumb – it’s really not. Our brains just crave consistency. This made perfect sense when the modern human brain first evolved some 50,000 years ago, but in today’s world of fancy finances, our love of patterns can lead us astray. A does not always lead to B. A might go to C and be influenced by D, leading to E or F. But our brains like to think A always goes to B. This is why, when we clean up the blackjack table for an hour, we think we’re invincible (even though we know, deep down, that we’re not). Unlike in blackjack, though, many people firmly believe they can beat the house (market). As we’ve discussed in early blog posts, the majority of investors do not beat the market average.

This search for a pattern can be seen broadly in how the small-time investor invests.  S/he buys when the market has been going up for a while (on the expectation that things are now ‘safe’ and prosperity will continue) and sells when the market is down significantly (on the expectation that it will get worse). As a result, like clockwork, the small-time investor consistently buys high and sells low, despite the fact that the fundamental goal of investing is to do the exact opposite.

This isn’t to say that trends don’t exist – they most certainly do.  But our brains’ “gut instinct” isn’t good at telling a real pattern from an imagined one.  And that, of course, is dangerous.

Joe Grammer works in a suicide prevention research lab at the National Naval Medical Base. At Community Ladders, he writes about psychology and how it relates to finance and consumer choices.