Cause / Effect Illusions

In 2008, Jennifer Whitson at UT-Austin and Adam Galinsky at Northwestern University published an article in Science that is relevant to trading the markets.

One study involved two groups of subjects watching two sets of images on a computer screen.

The first set of images was a series of paired symbols. Subjects were told the computer used a rule to generate the pairs and were asked to identify the rule. Group #1 received no feedback throughout the series whereas group #2 was randomly told “right” or “wrong” regardless of how they answered. This experimental design attempted to make subjects in the second group feel less confident for what was to come next.

The second set of “images” was nothing more than white noise. Upon flashing, all subjects were asked whether they saw anything and if so then what? The vast majority of responses were negative from subjects in the first group while subjects in the second group were significantly more likely to say yes.

Having experienced failure during the first set of images, group #2 approached the second set lacking a sense of control over its surroundings and was significantly more likely to falsely identify patterns.

In discussing the study, Whitson said:

     > All of these false/illusory patterns are connected. All of
     > them are influenced by lacking control so when people lack
     > control, they are more likely to see stock market trends that
     > don’t exist… they’re more likely to see conspiracies in the
     > world around them that don’t exist because it’s our instinctive
     > sense to try and react to the situation in which we lack
     > control by making sense of it and understanding it even if it’s
     > a false sense of understanding… this effect could explain why
     > religion is so successful among the poor or disenfranchised.
     > Whenever people feel like their lives are out of control, G-d
     > helps them make sense of things… there is a lot of randomness
     > in our lives. There is a lot of chaos. There are many, many,
     > many things we do not control. And so we have to pick out of
     > that chaos things that are meaningful to us to make a sensible
     > story out of our lives.

In conclusion, the brain seems more likely to identify patterns in what would otherwise be viewed as randomness when it feels out of control.

As traders never have control over what the market does, we should be careful about seeing definitive patterns that may not actually exist.