We’re all prewired to see patterns. But can we really do it? Let’s see. When you look at this chart, what do you see? And what do think will happen next?
It’s in our DNA to recognize patterns. For early civilizations, survival depended on it. Patterns in weather, tides and animal behavior told our ancestors when to hunt, migrate, plant and harvest.
Unfortunately, we’re so attuned to seeing patterns and trends, we can even see them when they’re not really there. And when they are there, we often attach more importance and meaning to them than they deserve. This can be a big problem for investors. When we expect history to repeat itself, we can make terrible decisions.
Time for the Sky to Fall?
For instance, here’s a pattern: Market drops of 15 percent or more have occurred, on average, about every 4.5 years since 1950. So, if there’s been no such drop for more than four years that must be a danger sign. An extended up market must mean that it’s time to sell, or will be soon, right? Definitely, unless the next big dip doesn’t roll around for 7.8 years, as happened from 1990–1998, during which time the S&P 500 gained more than 300 percent. (For more detail on this pattern, see “My Take: This is Only a Drill.”)
And here’s a pattern so well known it has its own slogan: “Sell in May and go away.” Anyone who trusted this old and widely accepted adage, which is based on a supposed pattern of summertime declines in stock prices, missed out on about 11 percent growth in the S&P 500 Index between May 2013 and November 2013, including dividends.
Like it or not, averages, cycles and trends summarize the past, but they don’t predict the future, especially in the short term. We want to see patterns because they make a big, complicated world easier to comprehend, but for anyone trying to pick stocks or time the market, the patterns we think we see just won’t help. In most cases, the patterns don’t mean anything about what will happen next, and it’s not possible to systematically know when they do mean something.
This is what happened next:
This chart shows the growth of an investment in one share of Key Bank (ticker: KEY) from 2000–2014 with dividends reinvested. What looked like a pattern of slow and steady growth in the first seven years didn’t tell us anything about what would happen next. It rarely does.
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