# Predicting the unpredictable – how to get it right

US NEUROSCIENTISTS have carried out studies into how the human brain identifies patterns and predicts results. These experiments have revealed that we often think we can see patterns that do not actually exist – and when it comes to investing, this can be a costly mistake.

The neuroscientists decided to compare how rats and human beings behaved in an experiment involving selection and random activity. The rats were given two buttons to encounter – one button, when pressed, gave the rats an edible treat eight times out of 10, but on the other two occasions, a small electric shock. The second button did the opposite (an edible treat was given on two out of 10 and an electric shock eight times out of 10). Once the rats determined that the first button gave better results, they subsequently selected only the first button. The neuroscientists called this their ‘maximising’ strategy.

The human beings were then shown a series of randomly generated red and green lights, with red lights illuminating more frequently than the green. On average, the red lights flashed eight times out of 10 and the green lights twice out of 10. The participants did not know that the sequences of lights were random or that there would be more red lights than green.

The results here revealed that the human beings were surprisingly accurate in estimating the frequency of the red against the green, predicting red around 80 per cent of the time and green 20 per cent of the time. However, they persisted in trying to predict the colour of the next light, even though it was random, because they were convinced that there was a pattern to the sequences. The neuroscientists called this their ‘matching’ strategy.

Selecting the food treats eight times out of 10 gave the rats a success rate of 80 per cent. By comparison, the human beings scored a success rate of 68 per cent. They predicted red 80 per cent of the time and of the red predictions, 80 per cent were red. For example, 0.80×0.80 = 64 per cent. They predicted green 20 per cent of the time and of the green predictions 20 per cent were green. For example, 0.20×0.20 = four per cent.

The neuroscientists hypothesised that human beings followed a less successful strategy because they believed that they could identify patterns where none existed.

The Russell Investment Group, one of the premier providers of multi-manager solutions, conducted similar experiments at conferences and investment seminars. The success rate of the human beings here averaged between 40 and 60 per cent, and, again, most of them assumed that there must be some sort of pattern, even though the images were in fact selected randomly.

The results of these experiments are interesting too, because this behaviour is reflected in the way many people pick their investments. The daily movements in financial markets can be compared with the random movements in the experiments. Despite the fact that the outcome cannot be predicted, man doggedly believes that it can.

The impact of our susceptibility to ‘seeing’ patterns that may not really exist can be seen in certain cash flow trends. History reveals that money tends to flow into stock markets when equities are doing well and into bond funds when equities are doing badly. In other words, many investors observe what is happening in the markets and make decisions on past performance.

But where money follows past performance, future performance doesn’t necessarily follow the money. In hindsight, past performance is often used to predict future performance … but the future cannot be predicted.

For example, if you look at the sharp rises and falls in the stock markets in the late 1990s and early 2000s, the peak of the monthly fund inflows happened in January 2000, after the market had been performing well, and the largest monthly outflow was in July 2002, after the market had performed poorly.

The impact of this type of investor behaviour on returns can be massive. According to research by US consultant, Dalbar, on the timing of investors’ investments into and out of US mutual funds, over the period from 1984 to 2003, the average equity fund investor in the US underperformed the broader market by 9.5 per cent per year. Dalbar concluded that the investment return is far more dependent on investor behaviour than fund performance.

The neuroscientists’ research revealed that human beings believe that they can predict the unpredictable, although rational thought might convince them otherwise. Or perhaps human beings just can’t resist a challenge?

So, how do we maximise our investment returns? Firstly, we should not assume that past performance is a reliable indication of what will happen in the future. Unforeseen events are happening all the time, which usually affect financial markets, and, again, these can’t be predicted.

A cool head is perhaps the best strategy. Be disciplined. Seek professional financial advice. Set your objectives and time horizons, and establish an investment strategy consistent with these goals.

Diversification is a financial strategy that consistently brings better returns than random investments. By spreading investments across a wide range of different types of bonds, equities, property funds and cash from various geographical regions, an unpredictable bad performance from one of these sectors can minimise the risk.

Ask your financial adviser about Russell’s Multi Asset, Multi Style, Multi Manager Approach. You could say that their past performance indicates that the future is predictably good!

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Contributed by

BILL BLEVINS

Financial

Correspondent,

Blevins Franks