The Danger of Investing in Patterns
A few days ago, I woke up knowing three things:
- I had to get to work
- I had to take the Beltway to get there
- It was raining
Armed with this knowledge, I decided to leave home early to make up for the plethora of accidents that would surely be on the road and the subsequent extra half-hour of traffic.
You’ll never guess what happened...
I made it to work in record time.
Even though the morning commute is notoriously bad without rain, I didn’t run into a single length of unusual traffic because of the weather.
Here’s why this particular commute was important enough to mention today...
All human beings share a few key traits. Among them is the dangerous habit of recognizing familiar patterns, even when they don’t actually exist.
This is called pareidolia, and you probably do it more often than you know.
It happens when you look at the design on a carpet or holes in a box and think you see a face.
It happens when you look at a cloud and think it’s shaped exactly like your dog.
And it happens when you look at historical charts and assume you know where a stock is about to move.
As with many things, we feel pretty justified in these assumptions. After all, the evidence is right there in front of you!
But in practice, the world is much more complicated than we like to give it credit for.
My morning commute was just one example: I assumed a rainy day would equal a rough ride. No one would blame me for harboring this assumption. However, it proved to be incorrect when the roads were perfectly reasonable to navigate — for once.
It’s even more dangerous to assume that past movements imply future outcomes when it’s your retirement at stake. Many people have lost fortunes that way...
What you have to do instead is take a step back and consider all the outside influences pushing a stock in either direction.
Has the company had consistent business for 30 straight years? That won’t matter if the industry it’s in is dying, or if a new competitor is poaching its clients.
Has a commodity been stable for a decade or more? Supply and demand are more volatile than you think, and maybe that producer you’ve put all your money into just struck gold.
These market swings aren’t always negative, but they will happen, and they will affect your stocks.
The only really predictable thing in this world is its unpredictability, and there will always, always be more changes on the way.
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Let’s look at another example: OPEC’s recent production cut.
When the meeting at the end of November was announced, we were skeptical. And we had every right to be, considering we’d been hearing about failed production cut meetings for two straight years.
But — color us surprised — OPEC finally announced that it had negotiated a cut! And moreover, it came to an agreement with a number of non-OPEC countries as well.
But this isn’t even the pattern we were really worried about...
“Unfortunately, we tend to cheat,” stated former Saudi oil minister Ali Al-Naimi earlier this month.
Before the glut took prices down to new lows, OPEC had already been pumping more than 1 million barrels of oil over its production ceiling, most of it coming from Saudi Arabia. When prices dropped, there was more of the same, which just exacerbated the glut.
In fact, the group broke out of another pattern in 2014 when it didn’t cut production to bolster prices as it had been known to do in the past. Al-Naimi was at the helm of that decision and has since been forced to give up his position.
Will we see another cycle back towards $30 oil?
It’s possible given OPEC’s history. And that’s not even considering the other known over-producers like Russia and Iran.
But I’m thinking Saudi Arabia will surprise us again by not letting prices get that low.
See, it only did so in the first place to starve out U.S. shale producers and hold onto market share. That didn’t work, and now shale operations are more affordable than ever.
Low prices also put several OPEC countries into near economic ruin and cost Saudi Arabia itself its own energy subsidies and a large chunk of its royal cash reserves. It doesn’t seem like it would be worth the fight to bring oil back down again.
It’s easy to assume a pattern is a sure bet, but sometimes logic really does win out.
Break the Pattern
This doesn’t mean there’s absolutely no way to tell where an investment will go, mind you. Who would invest at all if they weren't at least fairly sure they'd be making money?
Warren Buffett didn't become one of the richest men on the planet by guessing and hoping for the best. His mentor Benjamin Graham didn't build his wealth through sheer dumb luck.
They did it by making smart moves with their money and taking everything into account, not just past movements.
Keep an eye on cycles. Don’t knock historical averages.
But don’t assume you know everything about an investment because it looks familiar. There’s too much going on in the world for things to stay the same for long.
Until next time,
Energy and Capital
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