The human brain is incredibly adept at identifying patterns. It’s what allows us to prove we’re ‘not a robot’ when presented with one of those annoying ‘captchas’ when we’re shopping online. Then again, it’s also the reason some people think the Messiah is coming when they burn a slice of toast and a vaguely Jesus-like figure appears.
Our hard-wired tendency to occasionally perceive order amid random noise is usually fairly harmless. In fact, it may once have been critical to our chances of survival. The forces of evolution clearly found few downside risks in endowing us with a hyper-sensitivity to patterns. As Leonard Mlodinow puts it in The Drunkard’s Walk:
‘The ability to evaluate meaningful connections among different phenomena in our environment may be so important that it is worth seeing a few mirages. If a starving caveman sees an indistinct greenish blur on a distant rock, it is more costly to dismiss it as uninteresting when it is in reality a plump, tasty lizard than it is to race over and pounce on what turns out to be a few stray leaves. And so, that theory goes, we might have evolved to avoid the former mistake at the cost of sometimes making the latter.’
Unfortunately, for modern humans trying to make investment decisions, our pattern-hungry minds leave us highly prone to irrational actions. Opening an email last month, I was greeted by an ominous warning from a broker that I should be selling all of my bank shares. After all, June is nearly always ‘a terrible month’ for European banks. Sure enough, if you look at the performance of the European bank sector in June over the past four years, it doesn’t look great.
Source: Bloomberg as at 26 May 2017.
But is this a meaningful signal, or the investing equivalent of the Jesus/toast analogy?
Firstly, there’s a fairly clear sample size problem here. If you were to try to estimate the probability of a coin landing on heads by flipping a coin just four times, you’d run a very high risk of arriving at an erroneous conclusion. Long streaks are perfectly consistent with even entirely random processes, which is why it’s always important to ensure a sufficiently large sample size before jumping to conclusions. Sure enough, as soon as we look back over 30 years as opposed to four (the farthest back Bloomberg displays the data), the month of June immediately starts to look less spooky. In fact, in exactly 50% of Junes since 1987, European banks have delivered positive returns.
Source: Bloomberg as at 26 May 2017.
However, the statistics here are in many ways an unnecessary distraction. Fortunately there’s a far simpler way to tell this is dodgy investment advice. Simply remember, when confronted with this kind of seasonal argument for buying or selling equities, that shares aren’t tokens to be traded in a casino or squiggly lines on a Bloomberg screen. When you buy or sell a share, you are buying or selling an ownership stake in a real world, tangible business; and it is highly
unlikely that the fundamental value of that business (i.e. the discounted value of its future cash flows) will have radically changed because you’ve just flipped your calendar from May to June. The weakness of these kinds of arguments is that they’re based entirely on observations of past price changes, with no attempt to sense-check whether the observed price movements are likely to reflect changes in real world, fundamental values. This failure to differentiate between changes in price and changes in value lies at the root of all manner of stock market sins.
If you were to spend your entire life studying billions of slices of burnt toast, chances are you’d eventually stumble across a slice that resembles a familiar face; so if you spend your days staring at price charts, don’t be surprised to find patterns offering tantalising hints of predictability. Reacting to these perceived signals is far more likely to lead to costly overtrading than superior investment returns; and while there are undoubtedly important risks to consider when investing in European banks, the current position of the earth in its orbit around the sun is almost certainly not one of them.
[i]Mlodinow, Leonard. The Drunkard’s Walk: How Randomness Rules Our Lives (Penguin, 2009)