Monday, October 5, 2009

The Market Momentum Myth

It's a mistake to ascribe property of physics to human behaviour
With last week's drop of stock markets, has the market momentum "stalled?" Randy Park, author of “The Prediction Trap - and how to avoid it” (and a physicist) says that question is silly.
"Markets, or political fortunes, or other human behaviours don't have momentum - they don't have physical characteristics," says Park. "Where people are involved, ‘momentum’ cannot be used to predict the future."
When people talk about momentum, they are referring to something more accurately described as a herd mentality. "It's more than a matter of semantics," says Park. "Think of the behavioural differences between avalanches and antelopes." By ascribing momentum to human behaviour, people mislead themselves and use extrapolation to predict that situations will continue as they have in the past. This leads to decisions based on bad assumptions, as we have seen in both economics and politics.
While herds may have strong tendencies to continue in the same direction, a small surprise can cause an almost instant change in direction. What's more, if the same stimulus is repeated, it may cause a totally different response the next time.
Where does this inclination come from? "Whether you look at the evolutionary picture, or the development through childhood, people see momentum and extrapolation in everyday situations. A rolling ball continues in a straight line." People see this physical behaviour and incorrectly apply it to other situations.
Some argue that human behaviour can be predicted, and in some ways it can, if the important factors are exactly the same. Yet markets and political campaigns have so many complex, interacting variables, that the situation is never the same. And even if it were, people never see the same situation twice - the second time they have experience, which will modify their decisions.
The other key danger with using metaphors like momentum is the effect they have on our decision making process. "When people have an expectation in their head, they filter incoming information and look for information that supports their point of view," says Park. He listed some of the key differences in the thinking process when predicting a single future versus anticipating different possible futures:
Predicting - closed minded, only looking for supporting information, ignore facts, miss both obstacles and opportunities. Anticipating - more open minded, open to all evidence, see opportunities as well as obstacles.
A major newspaper provided an example of the danger of prediction just yesterday. With the recent release of economic data showing essentially flat economic performance, two articles appeared, both analyzing the information and presenting rational, logical arguments for their predictions. The problem was they were predicting opposite things!
"There are practical approaches that can be used to improve decision making and avoid these thinking traps," says Park. For business, he describes the use of System Dynamics, an approach which examines the structure of situations, including feedback loops, delays in information, and hidden influences. System Dynamics then uses mathematics to model the behaviour of the system. "System Dynamics can give a window into current and future performance, but its more valuable use is to reveal assumptions, and enhance communications and understanding in a group," says Park. System Dynamics can also provide input into exploring future scenarios.
Recently, Park was in Ottawa working with a group discussing the future of traffic management in the city. There were 30 people in the room. Now what would be the most important factor affecting future transportation? Gasoline prices. Yet everyone had different expectation of where gas prices would be fifteen years from now.
"We all operate with pictures in our head. When we communicate, we use words like 'up' and 'possibly'. Yet we each have our own interpretation of what these words mean. And even our own interpretation may change from day to day."

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