Pitfalls of Economics

Studies in neuroscience have shown that while the human brain excels at pattern matching, it does not distinguish well between perceived patterns and actual patterns. From a strictly evolutionary perspective, if you see a pattern that might indicate that there is a lion hiding in the long grass, you are better off assuming that there is one there than waiting around for better evidence.





For a quick demonstration of the mind ability to recognize patterns, consider the following:





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The inevitable consequence of this trait is that people will see "relationships" between actions that don't actually exist. Any person looking at a typical stock price chart will feel that he/she can predict where it will go based on where it has been.





Pure market technicians learn all they need to know from looking at the charts. Technical analysts have devised an entire mythology surrounding the future price projections by simply looking at a chart. They may only know the company by its ticker and have no idea what the company does. What's more they may boast that they do not even care.





Using little more than a ruler a technical analyst can draw various trend lines - primary, secondary, tertiary and can apparently tell you where the long-term price will go. Then there are the head-and-shoulders formations, the pan-handle, double-tops, and so on ... ad nauseum. Then for each of these, there seems to be an exception.





Elliot wave analysis uses a recurrent wave structure and has a various set of rules and counter-rules to explain how the entire system supposedly works.





Should it not matter that the company issued more stock to raise capital? What about payments on debt? Is revenue increasing or declining? How profitable was the last quarter? Are there recent labour, political, and/or environmental concerns? These questions should be of great concern to somebody purchasing shares in a company.





How exactly by looking only at a chart of historical prices and nothing else, can a prediction about the future be made? To me, this makes about as much sense as driving a car by looking out the rear window.





What is more interesting is that people are reluctant to change their pre-existing beliefs, even when presented with contradictory evidence.





"...the human understanding when it has once adopted an opinion draws all things else to support...it. And though there be a greater number and weight of instances to be found on the other side, yet these it either neglects and despises, or else by some distinction sets aside and rejects." (Francis Bacon, 1620)





People tend to seek confirmation of their hypotheses, rather than seeking refutation as in the scientific method. Confirmation bias is the tendency to search for and/or interpret new information in a way that confirms one's preconceptions and avoid information and interpretations that contradict prior beliefs.





Another reason for holding certain beliefs in spite of contrary evidence is because these beliefs make us happy. Wishful thinking is the formation of beliefs and making decisions according to what might be pleasing to imagine instead of by appealing to evidence or rationality.





We also believe many things we are told without asking whether they are true. This is especially true if the idea comes from a person of authority.





The outcome of the perpetuation of upholding these false beliefs is that much of the market analysis is flawed, overly optimistic and/or just simply false. When faced with an economic conclusion (as with any conclusion in life) make sure to investigate the assumptions upon which that conclusion is founded upon. A single false premise will result in a false conclusion regardless of the logic involved.





"Find the trend whose premise is false, and bet against it." (George Soros)





Published on www.DollarDaze.org - May 28, 2007.

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