I was listening recently to an interview on Bloomberg radio with Thomas Gilovich, a well-known professor of psychology at Cornell University. He has conducted research in social psychology and behavioral economics, with a focus on human biases in decision-making. He is the author of several books, including “How We Know What Isn’t So: The Fallibility of Human Reason in Everyday Life.”
Carl Sagan said of Gilovich’s work that it is “most illuminating” in showing “how people systematically err in understanding numbers, in rejecting unpleasant evidence, and in being influenced by the opinions of others.”
During an interview with Barry Ritholtz, Professor Gilovich touched on a lot of eye-opening topics related to human behavior, both market-related and otherwise. One of the themes of the interview explored why the human mind leads people to ignore some fundamental principles of mean reversion. Data over time will normally regress to the mean or average, yet people tend to remain “anchored” to what happened most recently. Whether it concerns the financial markets, sports, or everyday life, Gilovich maintains that
- we tend to see more patterns in the world than are there;
- we too often hold on to beliefs that do not fit the observed data; and
- we give too much credence to evidence that supports our beliefs and give too little credence to data that does not support our beliefs—confirmation bias is the “mother of all biases.”
Gilovich likes to use easily understood examples from the sports world to communicate some of his points. Three quick examples from the interview explore how overlooking mean-reversion theory can impact some common biases:
#1 “The Sports Illustrated Cover Jinx”: Over the years, people have maintained that appearing on the cover of Sports Illustrated (SI) is bad luck for an athlete. In fact, several pro athletes have turned down a cover for that reason. Gilovich points out that to be considered for a cover in the first place, an athlete usually had to have had an extraordinarily strong performance in his or her last season or last event. Simple mean reversion says that the odds are good that the athlete will not perform up to that standard in the next season or next event. So, while the SI effect might have a basis in observed data, it is not a “jinx,” but more likely reversion to the mean.
#2 “Don’t mention a no-hitter in the dugout”: Every baseball player from Little League on is told it is bad luck to mention a no-hitter in progress within earshot of the pitcher throwing the no-hitter. Gilovich says no-hitters, by definition, are an extremely rare occurrence outside the normal range of most games played. Players tend to remember when no-hitters were “lost” due to some loose lips in the dugout, when in fact the vast majority of no-hitters in progress never make it to fruition. “Bad luck” does not play a role either way, but people are selective in their memory.
#3 “Always give the ball to the player with the ‘hot hand’”: Gilovich, cognitive psychologist Amos Tversky, and statistician Robert Vallone wrote a paper in 1985 that debunked the notion that a “hot” player in sports (specifically basketball) is more likely to remain “hot”—put another way, that a player who has made a high percentage of shots in a game will be more likely to hit his or her next shots. Though somewhat controversial, their data supported the notion that “the hot hand fallacy can lead people to form incorrect assumptions regarding random events.”
What is one explanation for why both fans and coaches believe in the “hot hand theory”? People are more likely to remember a player who performed exceptionally (where he or she made, say, 14 out of 18 shots in a game) than they are the player who made five shots in a row and then reverted to the mean of average performance in that same game. Both random patterns might be achieved several times over thousands of games, but only one type is memorable.
In each of these cases, says Gilovich, individuals have preconceived notions that fly in the face of observed data or the explanation of observed data. He likes to summarize this form of confirmation bias in what he calls a “Freudian slip” from a conversation he once had. Many people, he says, operate from the perspective of “I’ll see it when I believe it.”
What does this discussion have to do with the market’s behavior over the past two trading weeks? A lot, I think.
While 1,000-point moves lower on the Dow Jones Industrial Average—and major index losses over 5% last week—certainly are attention-getting, in many ways, the markets have moved from an “abnormal” state to one that is regressing in several areas toward the mean.
All of the following show some level of mean reversion:
- A move away from a period of unusually low volatility.
- Higher bond yields and real interest rates (though still historically low), reinforced by a perceived level of slightly more hawkishness on the part of the Fed as they move toward “rate normalization.”
- A pickup in wage growth from a long period of wage stagnation, feeding some belief that inflation will rise.
- The end, at least for now, of a one-way street higher both in the markets and in bullish sentiment among professional and individual investors. According to Barron’s, the S&P 500 had completed its 10th-straight monthly gain in January 2018, “the longest winning streak since the 11 months ended January 1959.”
Flexible Plan Investments’ founder and president, Jerry Wagner, has been calling for some time for a pullback or correction. He has pointed it out in this space and in a recent article for Proactive Advisor Magazine:
“Stocks, as measured by the S&P 500, have been advancing without a 20% correction since March 9, 2009. That is the second-longest bull rally in the S&P 500’s history. Until recently, we had not even had a 5% correction in that Index for about a year and a half. In fact, up until the recent decline, the S&P 500 hadn’t fallen 3% from a previous high point (over one day or several days) since the slump that ended on November 4, 2016, four days prior to the November 2016 election. That stretch was the longest the S&P 500 had ever gone without a 3% or more retreat, according to Bespoke Investment Group.”
Two facts from Bespoke’s most recent analysis are noteworthy:
- Last Thursday (2/8/18), the S&P 500 closed 10% below its prior all-time high, ending the streak without a 10% correction at 715 calendar days.
- The S&P 500 dipped under its 200-day moving average (200-DMA) on Friday (2/9/18), but it still managed to close above it. That continues a streak of 409 trading days since the S&P last closed below its 200-DMA.
Will the market make a fast V-shaped recovery, back and fill for weeks or months, or head toward a deeper correction and possible bear market? While many theories abound in the financial press, no one knows for sure, of course.
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