Perception, Reality and Performance

SUSIE GHARIB: Before you buy a stock or a mutual fund, do you look at how it’s done in the past? Many people think past performance signals how an investment will do in the future. While that may seem reasonable, it could also be just an illusion. In tonight’s “Your Mind and Your Money” segment, produced in association with Kiplinger’s Personal Finance, Dan Grech explains.

DAN GRECH, NIGHTLY BUSINESS REPORT CORRESPONDENT: Patterns exist everywhere in nature, from the oceans’ tides to the intricacy of a spider web. But sometimes our brain sees patterns that don’t really exist. For instance, I’m not really very good at basketball, but let’s say I make two baskets in a row. My brain says the odds are in my favor of making the third shot as well even though the odds are mathematically the same. So when it comes to investing, do people make similar projections? Engineer Andy Gonzalez is studying for his master’s degree in finance. He sees mathematical patterns in nature and beyond.

ANDY GONZALEZ, MSF STUDENT, FLORIDA INTERNATIONAL UNIV.: For instance, when you throw a pebble into a pond, you start to see the ripple effects. You realize that’s a sinusoidal wave in mathematics, which is actually seen in various other places, including in the stock market.

GRECH: That’s why Gonzalez is a chartist. He looks at charts of a stock’s past price moves, like this one. In those charts he finds patterns that he believes indicate where that stock will go from here.

GONZALEZ: As long as you have back data of a particular commodity or stock or index, you should be able to see these particular patterns and determine whether it’s going to go up or whether it’s going to go down.

GRECH: But not all stock market observers agree. Princeton Professor Burton Malkiel wrote “A Random Walk Down Wall Street.”

BURTON MALKIEL, PROFESSOR, PRINCETON UNIV:. The stock market repeats itself sure. It goes down. There are bear markets. There are bull markets when it goes up. But it repeats itself in a number of different patterns. It doesn’t repeat itself exactly. And there is no way — I repeat — no way you can look at a chart of past stock prices, recognize that pattern and get yourself in and out at the right time.

GRECH: Investors are constantly warned that past performance is no indication of future returns. But University of Miami Professor Joseph Johnson says that advice is widely ignored.

JOSEPH JOHNSON, PROFESSOR, UNIVERSITY OF MIAMI: Mutual funds, they like to see a strong run of past returns in over a 10-year corridor or a five-year, a three-year.. That’s what we live for and those are the parameters of the rules that they use to how good the stock is or how good the mutual fund is. And as I said, when we talk about other walks of life that’s a very good rule. When we talk about mutual funds and stocks that’s a very bad rule because those
runs that are created are maybe out of chance.

GRECH: So why do people assume that an investment that’s been going up will keep going up? It may have something to do with human perception. Take this image. It shows two triangles, right? Well, if you look carefully, not even one triangle is fully drawn. Your brain fills in the lines to create two triangles. Professor Gregory Berns says when it comes to processing visual information, the brain seems to take short-cuts.

GREGORY BERNS, MD, PROF., EMORY UNIVERSITY MEDICAL SCHOOL: It really comes down to expectations. We process visual scenes in ways that we expect them to be, how we expect the world to behave.

GRECH: So when you think you see a pattern, ask yourself, am I inventing a pattern that doesn’t really exist? Dan Lebron Grech, NIGHTLY BUSINESS REPORT, Princeton, New Jersey.

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