Why 'pattern recognition' in investing can be the biggest enemy of an equity investor

By Dhirendra Kumar

Here’s a story from a few decades ago that set Daniel Kahneman on the path to the discoveries that eventually led to behavioural economics becoming a recognised phenomena, and Kahneman himself a Nobel Laureate in Economics despite the fact that he is a psychologist. More importantly for you and me as investors, we can discover from the story how easy it is to be wrong and yet be utterly convinced that we are right.

During the 1960s, Kahneman was a junior psychology professor at the Hebrew University of Jerusalem and had a part time assignment of giving psychology lectures to flight instructors of the Israeli Air Force. One of the things he explained to the flight instructors was that when a trainee pilot does well at a task, they should praise him but when he does badly, they should not criticise him. Based on everything he had learned in psychology, Kahneman was quite sure that this was correct.

However, the flight instructors disagreed. Their experience was the opposite. When a trainee did a flight maneuver well and they praised him, he would almost always do the next one badly. And if he did something badly and they screamed at the trainee, he would do the next one better. Kahneman was quite sure of what he was saying but these were experienced instructors and they were sure of what they had observed so he did not dismiss what they said out of hand. He kept thinking it over. Then he had the insight that set him on the path to behavioural economics.

He realised that while the screaming was followed by good performance, it was not its cause! Here’s what was actually happening. Each pilot had a certain skill level, which gradually improved as the training proceeded. Naturally, each trainee had some good days and some bad ones. These were distributed around an average that represented that trainee’s skill level. What was happening was simply regression to the mean. A good day in the aircraft had a higher likelihood of being followed by a bad day, and vice versa. However, because the instructors followed each day with either praise or criticism, it looked as if it was the feedback which was having a contrary impact. An almost random set of events had created a powerful impression of cause and effect which was utterly believable.

Can you see how this might have similarities to the way all of us take decisions about investments and how we come to conclusions about the impact of our decisions? The brain is an extremely powerful and persistent pattern-recognition system, to the extent that it will create believable patterns where none exist. After a few years of investing, whether in equities or in equity funds, all our brains are likely to be as clouded with false conclusions and misleading rules-of-thumb as those flight instructors.

The worst part is that exactly like the instructors, we all have ‘evidence’ that our rules work. They are perfect illusions. And when we make bad investments, we explain them away by making yet more spurious connections that are in effect, even more rules. Curiously, I find many more people who have made these little rules about timing the markets than about actually identifying good investments. Everyone seems to have these signals they follow about when to buy stocks and when not to buy and when and how to sell. Sometimes, purely due to chance, the rules actually appear to work and that just reinforces our beliefs.

So what’s the solution? The way I have described this phenomena, it looks like there is no solution. Actually, there is, and a very simple one. One word: automate. I don’t mean in the technology sense, but in the sense of rule-based investing. A perfect example of this is investing through an SIP in an equity mutual fund. That subjects you to an automated rule-based system that is not amenable to the ad hoc timing you may be tempted by. For equity investing, do the equivalent. For stocks that are in your buy list, just keep putting in a fixed amount of money at a regular period. In fact, that’s exactly the strategy that we recommend in our Value Research Stock Advisor service.

Remember, the pattern recognition that serves you so well in many other aspects of life can be your biggest enemy as an investor.

(The writer is CEO, Value Research)