Pseudoscience in the Investment World

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Skeptics generally tend to focus on paranormal claims to point out problems with critical thinking, but these exact same problems exist in other areas as well, including the investment world. Investors in the market have a very strong incentive to make predictions, to look for indications as to how the market will do in the future. Unfortunately, they rarely use scientifically sound means to make these predictions. In fact, most of their techniques have more in common with pseudoscience. In particular, since numbers are very important in the investment world, it is especially prone to Numerology.

Examining the investment world is an excellent way of demonstrating how skeptical thinking can be applied to all areas of life, not just the paranormal.

Contents

[edit] Predictions

Skeptics usually like to point out the failure of predictions of psychic mediums like Sylvia Browne, who makes predictions for the upcoming year and then, when that year is over, tries to rework some of her predictions to fit what actually happened. However, predictions of investors are usually no more sound and have no better track record, and yet skeptics are largely silent on the issue, even as investors publish dozens of newsletters making prediction after prediction for the next year.

Although few in the investment world will admit it, there just don't appear to be any such rules or trends for reliably predicting the market to any degree of specificity. In A.K. Dewdney's book 200% of Nothing: An Eye Opening Tour Through the Twists and Turns of Math Abuse and Innumeracy,[1] he examines the number of successful investment brokers and the level of their success and shows that, when viewed as a whole, they perform no better than would be expected by chance.

Fortunately, there are those who readily admit it. Harry Browne's book Fail Safe Investing[2] is based on this very idea. Also, in the commentary for the DVD Special Edition of The Princess Bride,[3] writer William Goldman recounts a conversation he had with investment manager Edward Neisser, who, when Goldman asked why the stock market went down, replied, "Because, Billy, it didn't go up." He went on to explain how the reasons why the market did what it did are always applied after the fact. On any given day, there might be reasons why the stock market would go down (a fire in a factory in the Philippines, say) and why it would go up (such-and-such corporation reported high profits). Analysts simply look for the reasons for the stock market doing whatever it did after they actually learn the results, but, like the Bible Codes, they seem unable to actually make the prediction before it happens.

[edit] Numerology

Numerology permeates the investment world. For example, in the late 1980s speculators predicted a rise in the price of gold; they looked at the rise of the gold price in the '70s to make their prediction. In the first half of the decade, the price of gold rose by a factor of 5, which is a Fibonacci number. In the latter half, it rose by a factor of 8, the next number in the Fibonacci sequence. They predicted that the next rise in gold prices would be by a factor of 13, the next Fibonacci number. This would have made the price of gold rise to over $3,000. This prediction was clearly false.

This example is not atypical. Investment advisors often rely on numerology, particularly Fibonacci numbers, to make their investment decisions even though there is no scientific evidence that Fibonacci numbers have anything at all to do with investment markets, and investment advisors have provided no reason why Fibonacci numbers should be significant. In his book Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression [4] (2002), Robert R. Prechter, Jr. used Fibonacci numbers to predict that 2003 would be an excellent year for short sellers (it wasn't) and that by the end of 2004 the Dow would fall below 5,000 (it didn't).

[edit] Confirmation Bias

The reason why people hold confidence in the predictions, and the reason why numerology is so prevalent, goes directly to an issue seen all the time with psychics and other paranormal phenomena. When selecting particular investments or picking which investment advisors to listen to, the concept of confirmation bias comes into play. The market might respond a particular way to an event on several occasions; an investment advisor might then make a prediction that, when that event happens again, the market will respond in the same way. But the advisor ignores all of the times when the event happened and the market didn't respond to it in the way he's predicting. With thousands of instances of investment activity every day, and years of it to look back on, it's not hard to find sequences that fit Fibonacci numbers or any other pattern one cares to look for. As in the realm of the paranormal, confirmation bias is used both as deliberate fraud and as unwitting confirmation of patterns and trends and predictability that just don't exist in the actual market.

Unfortunately, confirmation bias leads people to believe that certain investors have a special talent or gift for predicting the market. Pretcher (mentioned above) gained popularity because of a lucky streak early in his career, leading up to the 1987 stock market crash. Since then, he has been almost consistently wrong, and yet people still buy his books and take his advice. Pretcher is not at all atypical; many investment advisors base their careers on a lucky streak, and although there are a few investment advisers who seem to have a very strong track record spanning many years if not decades (Warren Buffet is perhaps the most popular example), there just aren't enough of them to think that there's anything more to it than their chance placement at the top of the bell curve.

Truly, the most accurate claim is always to be found in the standard disclaimer, "Past performance is no guarantee of future results."

[edit] References

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