...excerpt from Mo Lidsky's latest book, Partners in Preservation
In 1764, Thomas Bayes bequeathed one of the greatest gifts to investors. The essence of his contribution is outlined in Bayes’s work An Essay Towards Solving a Problem in the Doctrine of Chance. Putting the technical math aside, his basic message is that, given the infinite factors contributing to movements in financial markets, the best we can do is a probability distribution. One cannot say with certainty that markets will rise 8 percent. One could, however, potentially determine that, based on historic trends, there is a 20 percent chance of markets rising 8–12 percent, a 40 percent chance of markets rising 1–7 percent, and a 30 percent chance of markets falling 1–7 percent, and finally a 10 percent chance of losses or gains exceeding those numbers.
This approach, however, is in sharp contrast with the majority of forecasters, speculators, and market timers attempting to convince you of their confidence in the markets. Savvy investors and advisors don’t rely on forecasts or predictions of the future. Instead, they take their time analyzing all potential risks and the probability of those risks materializing, and they carefully identify ways to mitigate those exposures.
Behavioral psychologists have demonstrated that there are other benefits for taking one’s time to consider probabilities—namely, it will help one avoid being subjected to harmful biases and poor choices. Researchers Eric Gold and Gordon Hester at Carnegie Mellon University exposed our irrationality in spotting trends (E. Gold and G. Hester, The Gambler’s Fallacy and the Coin’s Memory). They showed that if someone flipped a coin and it fell on heads four consecutive times, the person will assume the probability of the fifth toss being tails is now higher* (This phenomenon has been referred to as the gambler’s fallacy). This is, of course, despite the fact that the probability of the fifth, sixth, seventh, and every toss thereafter still has a 50 percent chance of landing on heads.
Humans are by nature pattern seekers even where no pattern exists. In a fascinating study, subjects were asked to guess whether a light would flash at the top or the bottom of a computer screen. Unbeknownst to the participants, researchers set 80 percent of all flashes to randomly appear at the top. The study was done on adults, young children, and even animals (pigeons and mice). Once animals or young children realized that flashes were predominantly at the top, they proceeded to choose the top of the screen for all successive guesses, effectively getting the answer correct 80 percent of the time. Adults and older children, however, were not content with just guessing the top each time and tried to figure out the pattern in which the light flashed. As a result, they only guessed correctly 64 percent of the time (M. S. Gazzaniga, Who’s in Charge? Free Will and the Science of the Brain). Thus, our search for patterns often prompts us to neglect or discount probabilities.
There is a solution to our relentless pattern seeking. In the coin toss example, the experimenters discovered that if the subject stepped away after the fourth coin toss and returned some time later, the subject’s perception of probabilities reverted back to fifty-fifty (G. Wolford, S. E. Newman, M. B. Miller, and G. S. Wig, “Searching for Patterns in Random Sequences,” Canadian Journal of Experimental Psychology).
This suggests that one simple way to protect yourself from being subject to unhealthy biases, looking for patterns where none exist, or generally poor investment decisions is simply to take your time.