Looking for patterns in markets

September 16, 2022

At my son's 8th grade curriculum night yesterday evening, his teacher informed us that the kids would be starting a financial literacy unit. They were going to discuss ways to save and invest. At home, I asked my son if he was interested in savings accounts or indexing as a strategy to invest the money he makes taking care of the neighbors' cats.

"Neither dad. I'm interested in high frequency trading."

This was not music to my ears, so the discussion went deep into the evening on this topic, which had the positive effect for me of thinking I was doing good parenting, and for him of delaying bedtime. High frequency traders look for patterns. Indexers assume the patterns are all competed away quickly, in part by the high frequency traders. Here is Andrew Lo, Professor of Finance at MIT:

"As soon as you start doing this, the pattern disappears… in financial markets, the moment you try to take advantage of this pattern, the pattern changes. In fact, the more you try to take advantage of it, the more quickly the pattern changes. If there are a lot of people trying to predict patterns — then you get no pattern. You get randomness. That’s the idea behind an efficient market being random. If it were not random, then that means that there aren’t enough people who are bothering to try to forecast the price and incorporate information into the price.”

Indexers believe in the efficient market. That patterns, particularly in the short term, aren't really a thing.

The problem is that patterns help to relieve anxiety. Patterns feel safe, they feel predictable. If you believe you see a pattern in something, you believe you know what's coming next, and that feels good. Much of our lives depends on being predictable and dependable. That's one of the differences of being an adult and being in 8th grade - you don't decide, randomly, that shoes are no longer necessary. The pattern is you put your shoes on in the morning.

In finance, what happens is that people look for patterns, and not just the high-frequency traders. There are endless silly reports from finance firms that say "We see XYZ occurring in the economy, and as such we expect to happen." The problem is there are so many potential patterns that if you look hard enough, you can find almost anything to believe. And how they all relate and affect each other is impossible to predict.

What to do? At least in finance, and probably in life, extending your time horizons to the medium and long term timeframe improves confidence in pattern seeking.

Dan Cunningham

<sup>1. This is a great read if you are interested in a high frequency trader, Renaissance Technologies, who did, in fact, beat the market.
2. If some economics concepts seem dry to you, I recommend the Cartoon series on microeconomics or macroeconomics. These are surprisingly good books.</sup>