Tuesday, January 15, 2008

Behavioral Finance – Pavlovian Association

This is the fifth in a series of posts about common human misjudgments. The series is based on a Charlie Munger speech at the Harvard Law School in 1995.

Why study human behavior in relation to finances?
Recognizing and understanding why people do the things they do, what drives them, and what are innately human tendencies is the first step in overcoming your own self and making sound decisions! We want to make rational, logical decisions, but emotions and irrational tendencies get in the way.

5. Pavlovian Association
Most are familiar with the famous Pavlov experiments. By applying stimuli to animals in a variety of ways, using sound, visual, and tactile stimulation, Pavlov was able to make the animals salivate whether they were in the presence of food or not; a phenomenon he called the conditioned reflex. The stimulus or pattern of events was enough to trigger a response.

Searching for patterns
People have a tendency to misconstrue past correlations in decision making. It’s human nature to look for patterns, even when no pattern exists. We are always trying to draw a parallel between the unknown and the known.

This is a very worthwhile trait. People that could recognize patterns could use previous known solutions and apply that to the new problem to solve it. Recognizing patterns helped ensure survival years ago.

For instance, knowing what time the deer feed or go to water each day, allows one to get there ahead of the deer, setup and be ready to hunt. Consequently, seeing a pattern can improve your success rate at taking deer and feeding your family. Likewise, recognizing the changing seasons, the angle of the sun and when the best time to plant crops is also pattern recognition.

How can this be a problem?
Issues occur when people assign events to patterns that are not truly patterns. They are random events and having no correlation. You are essentially fooling yourself.

Some financial analysts use technical analysis to time their trades. The technical analyst is looking for patterns in stock charts and expecting them to repeat so as to predict the future of a stocks performance. Is this luck? Or serious analysis?

I personally believe that there are general patterns or trends to the market, but, I also recognize that selecting a stock because of the shape of it’s previous trading history is much less likely to be as sound an investment as selecting a stock because of it's intrinsic value.

No comments:

Post a Comment