Pareidolia refers to the human tendency to perceive patterns where, in fact, there is only randomness. This may sound like a complex phenomenon, but if you’ve ever marveled at the man in the moon or distinguished the face of a horse and buggy in a passing cumulus cloud, then you are already familiar with the process of interpreting significance where, in fact, there is none.
These instances of pareidolia—and other well-known examples, such as religious icons appearing in the markings on a piece of toast—seem harmless enough. When it comes to investing, however, pareidolia can have more serious consequences. If you misinterpret market information, mistaking the noise for an actionable pattern, you may end up with big investment losses.
This article analyzes our inclination for envisioning orderliness when faced with an unpredictable and often messy reality, considers the dangers of pareidolia in stock trading, and suggests some strategies to avoid it.
Imagining Order
It is likely that everyone has experienced some form of pareidolia, such as recognizing the form of a human face in a rock formation or some other inanimate object. In the past, psychologists deemed pareidolia to be a sign of mental illness, but scientists have more recently accepted the phenomenon as a common and normal part of human perception.
Our tendency to perceive patterns when faced with random stimuli stems from the human brain’s distaste for disorder and unpredictability. Faced with ill-defined and vague information, we perceive patterns as a way of making sense of the world. Despite some inevitable misunderstandings, this ability is central to our ability to learn.
Beyond our basic thirst for meaning, the specific type of pareidolia where we see faces in different objects may have its own evolutionary logic. The capacity to detect a face—and determine whether it belongs to a friend or a foe—has important implications for survival. This explains why, in addition to recognizing the shape of a face in the patches on a potato, we can even perceive whether it has a happy, sad, or angry expression.
Is it rare to have pareidolia?
Although pareidolia was once thought of as a symptom of psychosis, it is now understood as a common part of the human experience. This is particularly true about recognizing the patterns of faces in inanimate objects, which may be tied to the evolutionary need for quickly deciphering facial expressions.
How do you recognize patterns in the stock market?
There are many ways to recognize patterns on a stock chart. The strategy for interpreting market data based on chart patterns is known as technical analysis. Proponents of technical analysis often use Japanese candlestick charts and look for established patterns with colorful names such as three white soldiers or abandoned baby. However, it is important to remember that these patterns describe only past performance and are subject to pareidolia.
In The Stock Market Pareidolia Gets Dangerous Fast!
Pareidolia has wiped out the majority of traders in the stock market.
I’ve mentioned this stat again and again:
It doesn’t matter if you follow technical or fundamental analysis 95% of traders lose money.
It’s not because you’re undisciplined, it’s because you’re not using the right tools.
What does everyone like to jabber on about in stock market forums, CNBC, around the water cooler at work, and in books written 50 years ago by some dead “guru”?
Technical analysis, “head and shoulders patterns”, “double-tops”, “cup-and-handle” patterns…
It’s all very easy to see on a computer screen, just like looking at clouds in the sky.
Unfortunately, when you start doing things like writing computer programs to test these patterns, these ideas quickly break down.
How do you tell a computer what a head and shoulder pattern is?
What exactly is a double top, what’s a cup and handle?
What even is a candlestick when you can make them in any random time frame?
Look For Things That Are More Basic
You need to understand that most of the daily movement in the stock market is just random noise.
There’s very little signal at all in these price movements.
If you start looking for all these complex patterns you’re only going to get maybe a handful of trades per year.
And there is no way in hell you’re going to be able to get any significance out of those patterns whatsoever.
All technical and fundamental analysis breaks down at a certain point.
That certain point is called testing.
It’s called using the scientific method instead of using your eyeballs to do the judging.
We, humans, do a lot of things right, but we also do a lot of things wrong.
And trading is one of them.
Start connecting the dots, and start translating your ideas into computer code before you risk a single dime on the latest trading idea du jour.
Instead of applying your mental prowess to find shapes and mystical meanings in grilled cheese sandwiches, look for things that are more basic and statistically significant.
