Blog #56 Why We Persist in the Prediction Illusion?

The last few blogs sports a central theme: stock market prediction is a loser’s game for 99% of humanity (the other 1% are the odd investment geniuses we now know but wished we had known much earlier).

If market timing, momentum trading, contrarian trading, technical analysis etc. are detrimental to our wealth, then why do so many still swear by these activities? I believe that the reasons lie beyond finance and has a lot to do with psychology.  In particular, understanding how our beliefs inform or misinform us is the first crucial step in improving the way we manage our personal finance and investments.

At the risk of over-simplifying a huge literature on this subject, here are three main reasons why we often become victims of the loser’s game:

#1 We are pattern-seekers.
The “we” here refers to practically all of us. This is because the normal human brain is hard-wired to look for patterns, whether they are cloud patterns or patterns in stock prices. But as I’ve mentioned many times, stock prices are actually pretty random (which is why they are often described as ‘random walks’). We don’t see them as random because we look with the benefit of hindsight. But hindsight is a poor guide to the future when the underlying object of prediction has a high noise-to-signal ratio as is the case with the prices of financial securities.

#2 We have a poor understanding of probability.
You throw a fair coin six times and you get HHHHHT. We have trouble making the correct sense out of such situations. Some of us will think that the next throw will have a more than 50% chance of landing on a head (after all, there seems to be ‘momentum’ in the coin tosses so far). Others will disagree and bet that the next throw will land on a tail (reasoning that a tail is long ‘overdue’). Both reasoning would be wrong in the current context; heads and tails both have an equal chance of appearing in any given coin toss. We laugh at the folks who fail this simple probability test, yet we fall into a similar trap when we try to second guess future stock price changes based solely on how they have moved in the past.

#3 We regularly get our timing of thoughts and events mixed up.
Have you ever felt as though you predicted exactly when the traffic light is going to turn green, or sensed that the doorbell is about to ring? Did you think you had a sixth sense or a god-given clairvoyance for getting these predictions right? Or did you attribute them to pure coincidence?

Recent psychology research [1] shows that people who think they are “special” are also more likely to think that they have some sort of clairvoyance. The research was designed as follows. First, the subjects of the experiment were asked questions to assess whether they think they have special abilities to tell the future. Next, these subjects were asked to play a game in which they were asked to quickly predict which of 5 white squares was about to turn red. Importantly, the square that turned red from one trial to another was chosen randomly. Therefore, it was impossible to correctly predict the red square with a higher probability than 1 in 5 or 20% (this random aspect of the experiment was known only to the researchers).

Subjects could either indicate that they didn’t have time to finish making a prediction before the red square shows up, or they can state that they did make their prediction before this event and predicted either correctly or incorrectly. If subjects got the timing of their thoughts and the event mixed up, they might think they made the right prediction before the red square turns up more often than chance would explain. Let’s call them the mis-timers. As it turns out, there were indeed many mis-timers. More interestingly, mis-timers were more likely to have delusional beliefs in their “special abilities”.  The study therefore hints at a basic deficit in the brain machinery that plays to folks with the flawed belief that somehow, they are blessed with the superhuman ability to tell the future.

[1] See Adam Bear, Rebecca Fortgang, and Michael Bronstein (2017), “Mistiming of thought and perception predicts delutionality”, Proceedings of the National Academy of Sciences.  Here is the article link.



Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s