NEW YORK (MONEY Magazine) - If you show people a sequence of anything -- numbers, colors, shapes, letters, faces -- and tell them that the arrangement is random, they will insist on believing that they can predict the next item in the series. Examples are everywhere: We "know" that a baseball player is "due" for a base hit, we're "sure" that our next roll of the dice will be a seven, we can tell that our "lucky number" will be the winner in this week's lottery.
Technical analysts insist that charts of past prices can predict the path of future returns -- and every Wall Street strategist thinks he can forecast where the market is headed, especially when you seat him in front of a TV camera. At heart, all of us (even market strategists) know that these things are utterly unpredictable. So why do we persist in trying to predict them?
It turns out that we have no choice. Our brains are wired to force us into forecasting; it is a biological imperative. In fact, humans are born with what I've come to call "the prediction addiction."
Two areas of your brain, the nucleus accumbens and the anterior cingulate, specialize in recognizing patterns and choosing between conflicting alternatives. The nucleus accumbens lies on the bottom surface of the front of your brain; the anterior cingulate is in the central frontal area. These areas click into life when the stimuli around you either repeat or alternate. Repetition (this plant always has edible roots) and alternation (day always follows night) were the two most basic patterns primitive man had to recognize. After millions of years of evolution, our brains now respond to these simple patterns unconsciously, automatically and involuntarily. You don't even realize that you're searching for patterns -- and you can't stop it, any more than you can order your heart to cease beating or your lungs to shut down.
What's more, these two parts of your brain (along with other, interconnected structures) pounce on patterns almost instantly. Scott Huettel, a neuroscientist at Duke University, recently found that the anterior cingulate begins to anticipate another repetition after a stimulus occurs only twice in a row. (There's neural truth in the old saying, "Three's a trend.") In other words, as soon as a stock beats earnings forecasts for two consecutive quarters, or a fund outperforms the market for two straight years, an "I get it" effect kicks in -- the conviction that you know what's coming next.
But Huettel's experiments show that there's a dark side to this trait. If a repeating pattern is broken (as it so often is in the financial markets), then batches of neurons suddenly flare in the insula, caudate and putamen -- areas of the inner brain that, like the amygdala, can generate feelings of fear and anxiety. That may help explain why, when the earnings of "predictable" growth companies stop growing, investors bail out and these stocks can lose billions of dollars in market value in a matter of moments.
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Huettel also found that the longer a pattern has previously repeated, the more violently your brain responds when the pattern is broken. The stock market bears out Huettel's laboratory findings: A recent study by Irene Kim, a finance scholar at the University of Michigan, shows that the more times in a row a company has topped Wall Street's expectations, the further its stock drops when it finally falls short of analyst forecasts. While a shortfall after a run of three good earnings reports trims just 3 percent off the price of the average growth stock, a miss after a string of eight positive quarters hacks off an average of 8 percent. (One recent example: In July, after eight straight quarters of "beating the Street," NCR Corp. earned one penny less than expected -- and lost 15 percent of its value in a day.)
And what about value investing? Value stocks tend to have lumpier, less linear earnings; as their profits and share prices bounce around, our brains probably seek to interpret them as an alternating pattern. But alternation is hard for us to grasp. Huettel has shown that the anterior cingulate takes much longer to "make a representation" of an alternating pattern than a repeating one -- about six iterations, as opposed to two. That may show why value stocks are so consistently underpriced: Because the path of their earnings growth is more erratic in the short run, your anterior cingulate struggles harder to predict what's coming next. In fact, that short-term focus of our brains leads us to overlook the longer-term truth: Over the course of many years, the earnings growth rate of value stocks is barely lower than that of their growth counterparts and, in the long run, value investing is at least as lucrative as a growth-only strategy.
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