It’s amazing how every little bump and
dip in the stock market demands an explanation. There are
plenty of good reasons on offer: Portfolio window
dressing, relief rallies, profit taking, housing starts,
employment reports et cetera are all part of a lexicon to
provide justification for the day’s market action. But
you will never hear an analyst say, "The market went
up 50 points due to a random statistical blip." The
idea that chance is a factor in stock prices seems to fly
in the face of common sense.
Thomas Gilovich, a professor of psychology at Cornell
University in Ithaca, N.Y., illustrates the non-intuitive
nature of randomness to his students this way. He asks
each member of his statistics class to write down a mock
series of 20 random coin flips and to represent that
series on a piece of paper using X’s and O’s to designate
heads and tails. One student is told to actually flip a
coin and write down the results.
Mr. Gilovich is always able to ferret out the one with
the real-life coin flips. He is able to do so because his
students always underestimate the likelihood that chance
will result in a bunching of heads and tails. Like most
people, they imagine that a 50-50 probability will even
out in a fairly small sample. (Try this for yourself. We
did and got XOXOXXOXXOOXXOOXXOXX, a 12-8 majority
to heads!)
Our daily lives are peppered with such
misunderstandings of the effects of randomness, and we
insist on seeing patterns where none exist. A
particularly pervasive example is in political
polling.
These surveys have become more and more common since
the days of George Horace Gallup. In this year’s US
presidential election, pollster John Zogby is producing a
new poll each and every day from Sept. 29 until election
day. And every day this close contest carries the same
disclaimer, "Since the daily tracking poll began, the
race has never been outside the survey’s statistical
margin of error of plus or minus three percentage
points."
Okay, so the election is too close to call. But it
doesn’t stop there. The daily headlines from sponsors
MSNBC and Reuters rhapsodize like sportscasters calling
the Queen’s Plate. Every nuance of the candidates'
performance is examined and a line is drawn to today’s
numbers. Al Gore sighs too loudly and George W. Bush goes
in front. Mr. Gore increases his lead with Soccer Moms
and closes the gap.
Every one of these embellishments can be more
plausibly explained by simple random distribution. A tiny
wobble here and there and the script would be completely
different. It gives journalists something to write about,
but it is no more relevant than the chat on the psychic
channel. At least there the disclaimer at the bottom of
the screen is clearer: "For entertainment purposes
only."
The ebb and flow of the business cycle and investor
psychology create many patterns that are useful to
investors for stock selection and helping to time buys
and sells. The enormous challenge is to eliminate all of
the quirks of normal statistical randomness and focus on
those connected to fundamental trends. That’s easier said
than done, for if these could be easily separated, making
money would be no harder than printing tide tables.
By paying attention to the "signal to noise"
ratio when absorbing information, it is easier to filter
out the meaningless jabber and concentrate on the
fundamentals. Avoid the tendency to overanalyze today’s
news, and remember, sometimes things just happen, because
they happen.
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