Red Touches Yellow, Dangerous Fellow: Why Pattern Recognition Is Good For Snakes, But Not Stocks

August 15, 2013  |  

Red Touches Yellow, Dangerous Fellow: Why Pattern Recognition Is Good For Snakes, But Not Stocks

snakeThe ability to recognize patterns helps you to survive, especially when it enables you to recognize and steer clear of danger. However, the value of pattern recognition is not universal. Unfortunately, this skill won’t help you thrive as an investor.

Patterns Can Help You Avoid The Dangers of Everyday Life

You may have learned this rhyme as a child to help you identify a poisonous snake:

Red touches yellow, dangerous fellow.
Red touches black, friend of Jack.

It’s a great example of how pattern recognition can help in some cases.

Patterns like this encourage people to believe in the value of pattern recognition in other aspects of life. Over time, those who failed to recognize dangerous patterns and picked up the wrong snake didn’t survive. Over the generations, this has reinforced our tendency to use pattern recognition for survival.

Today, we are so hardwired to see patterns that we sometimes see them where they don’t exist. As a result, we draw false conclusions. This is okay when it keeps us away from safe snakes as well as dangerous snakes, but it’s not good when it gives us a false sense of security about our investments.

Patterns Aren’t as Effective in the Investment World

Given the value of pattern recognition, it seems natural to seek and act on patterns in investment returns. The problem is that patterns don’t predict how the prices of stocks, bonds, or other investments will perform.

Academic research as early as 1900 argued against the existence of patterns in investment returns. French mathematician Louis Bachelier theorized that stock prices follow a “random walk,” meaning that they follow no set pattern. He also said, “There is no useful information contained in the historical price movements of securities.”

Bachelier’s idea was most famously developed by the University of Chicago’s Eugene Fama. Writing about the “random walk,” Fama stated, “This theory casts serious doubt on many other methods for describing and predicting stock price behavior.” His 1965 article for the Financial Analysts Journal is a widely cited classic that has become the foundation of much more research.

Since then, the evidence against using pattern recognition as an investment strategy has mounted.

Today, the weight of the empirical evidence leads us to believe that:

  • Tomorrow’s stock price can’t be predicted from today’s stock price.
  • Technical analysis, which is the study of stock-price patterns, is of no value to the investor.
  • The ability to consistently predict future market movements does not exist.

In short, our skills in pattern recognition are of no value in the field of investments.

What’s The Alternative to Pattern Recognition?

If pattern recognition isn’t useful for investment strategy, what other techniques can an investor use to avoid danger and take advantage of opportunities?

In light of all of the evidence, investors should construct their portfolios with their personal goals in mind, a laser-like focus on costs, and rigorous discipline. In our experience, investors are best served by following these tenets and ignoring their natural tendency to see patterns in what are essentially random numbers.

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About Chas Boinske

Charles P. Boinske, CFA, is a 30 year investment management veteran overseeing the strategic direction and portfolio management process for Independence Advisors, LLC. Have a question for Charles? CLICK HERE TO ASK CHARLES

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