Random Thoughts

January 27, 2010

The Toronto media is abuzz with stories about jaywalking. Over the last two weeks, 14 pedestrians have died while crossing the street in the Greater Toronto Area, a surprising rate of carnage in a city that sees about 30 pedestrian deaths in a typical year. “Why aren’t we talking about lowering speed limits, increasing penalties or narrowing city streets?” asked one outraged scribe in The Toronto Star. The Sun called the deaths “a worrying trend for safety experts.”

So what does this have to do with investing, you ask? It’s a classic example of our inability to accept randomness: the same human failing that compels us to ascribe a rational explanation to every move in the stock market.

Humans are hard-wired to explain things with stories. A large number of pedestrians killed in a two-week span? It must be “a worrying trend” caused by fast drivers and wide streets. Except that drivers aren’t going any faster than they were three weeks ago, and the roads aren’t any wider. Overall, the number of deaths on Toronto roads has been trending down for years. Why is it so hard to accept that the current spate of pedestrian casualties is simply a random statistical event?

You don’t have to look very hard to find similarly fatuous explanations of stock market movements. The Toronto Star’s website explained on Wednesday that the Canadian market finished lower after the Federal Reserve announced that interest rates would remain unchanged and the economy is improving. Meanwhile, news outlets south of the border reported that US stocks went up for the same reason. The same news is followed by opposite results, and yet it’s used as an explanation for both.

Our love of narrative even leads us to concoct investing “strategies” that sound reasonable, but have no basis in reality. The population is aging, so you should invest in companies that provide health care and other services for the elderly. The Chinese are buying a million cars a month, so the price of oil will go up based on increased demand. My favourite yarn is the one that urges people to invest in gold in September, because that’s when people in India begin buying jewellery for the traditional wedding season, driving up its price. A lovely tale, but if there’s a more ridiculous investment strategy than that one, I’d love to hear it.

All investors would be better off if they simply accepted that markets move in unpredictable ways. Trying to explain yesterday’s dip by pointing to a single piece of news—or worse, spinning stories that predict where the price of stocks or commodities will go next—is senseless. Let the mutual fund managers and stock pickers do that while you buy the whole market and embrace it in all its randomness.

And be careful crossing the street.

{ 5 comments… read them below or add one }

moneyxyz January 28, 2010 at 12:24 pm

Good post. :)

moneyxyz January 28, 2010 at 12:24 pm

Why doesn’t this “The population is aging, so you should invest in companies that provide health care and other services for the elderly.” have basis in reality? It sounds plausible to me.

Canadian Couch Potato January 28, 2010 at 2:42 pm

The fact that the population is aging is, of course, true. But it doesn’t follow that companies who deliver health care or other services to the elderly will, as a result, be good stock picks. If the prospects are bright for these companies because of the demographics, then that information is already factored into the price. That’s what the theory of efficient markets is all about.

Steve March 26, 2010 at 11:00 am

I had heard of this blog before, but I had no idea how well written and informative it was. Seriously Dan, thank you. The idea of randomness and our tendency as humans to attribute meaning to it has been something I’ve thought about for years. There’s a wonderful book you may know about by the late Stephen Jay Gould. It’s called Full House and it’s about exactly this topic. His take on the extinction of .400 hitters in baseball is brilliant because whereas everyone else looks for a ‘reason’ (e.g., too much pressure, too much travel, better pitching, etc.), he just looks at numbers and sees shrinking variation around a mean.

Canadian Couch Potato March 26, 2010 at 11:29 am

Thanks, Steve. I’m a fan of Stephen Jay Gould and baseball, so I really liked that discussion in Full House. Hope you keep enjoying the blog.

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