Logics that drive Stock Price Patterns

Ask your kid to wake up in the morning or go to bed at night and you are likely to get a not so positive response. Ask an employee to perform certain difficult task and you need to ensure the employee is motivated. Incentives play a major role in motivating one to perform to achieve the desired goals. If the incentive is instant, the impact is likely to be better. That is human nature. Most organisations understand this well and devise reward programs for employees.

Often, in the world of investments, the results of the investments turn out to be very different from what logic can explain and there are situations when a wrong decision gets rewarded just because of the random nature of stock markets. Stock market is a very different place in that way. What we mean to say here is that even at times when one has invested for wrong reasons, or made wrong investment choices, the outcome turns out to be positive. Such an outcome leads one to believe that the decision and the logic behind the decision were right. On other occasions, when one has taken the right approach to assessing an investment, if the outcome is negative, one tends to question the investment process. In both the cases, the outcome may determine the future course of action. An investor making a mistake and getting the right outcome is likely to put more money using the same investment process. The moment the outcome changes, i.e., the negative outcome appears, the investor, in all likelihood loses more than he ever gained. On the other hand, if the outcome was negative in the first place, the correct methodology was either changed or the investor opts to stay away from stock markets.

This is no different from the famous experiment by the scientist Pavlov:

The original and most famous example of classical conditioning involved the salivary conditioning of Pavlov's dogs. During his research on the physiology of digestion in dogs, Pavlov noticed that, rather than simply salivating in the presence of meat powder (an innate response to food that he called the unconditioned response), the dogs began to salivate in the presence of the lab technician who normally fed them. Pavlov called these psychic secretions. From this observation he predicted that, if a particular stimulus in the dog’s surroundings were present when the dog was presented with meat powder, then this stimulus would become associated with food and cause salivation on its own. In his initial experiment, Pavlov used bells to call the dogs to their food and, after a few repetitions, the dogs started to salivate in response to the bell. (Source: www.wikipedia.org)

To put the above paragraph simply, while the dogs were expected to salivate on seeing meat, they started salivating even at the sight of the lab technician, who brought them meat. In the second experiment, when Pavlov started using bells to call dogs to their food, the dogs started to salivate at the sound of the bells even when there was no food. The brain learns and remembers using association. Sound of bells or sight of lab technician was followed by food – in the above discussion. This theory won the Nobel Prize for Ivan Pavlov and goes a long way in explaining how learning can take place.

It's human nature to find patterns where there are none and to find skill where luck is a more likely explanation – said William Bernstein

I would narrate an incident that happened long back with a college student. This student happened to be one of the toppers in his class but was always very nervous during the examinations. In his final year, he had prepared well for the exams like he always did. On the day of the first exam, he was sitting on a tea stall having his morning cup of tea. Whether it was nervousness or something else, he dropped the cup and it broke. That day, he did fantastically well in the exam. It became a routine for him from the next day onwards. Every morning, he would go to the same tea stall, have tea, pay the tea stall owner Rs. 5 and break a cup. This was exhibition of the same behavior that William Bernstein mentioned above – “find patterns where there are none” just because one was unsure of the outcome of the exams. We can look around ourselves and find many such examples in real life as well.

It is no wonder then that around the budget time, we hear talks about pre-budget rallies / crashes or post-budget rallies / crashes. The announcements in the budget still can make some difference to certain businesses and the economy at large, but then there is also the December effect or the May-June crash phenomena – just because someone happened to register similar movements of stock prices during those periods.
 
However, there is a difference between the patterns that cause the prices to move and those that just randomly happen more often. The most important pattern and a proven one at that is the relationship between company profits and the stock price. The stock price moves in line with the growth in the profits of the company. As long as the company continues to grow profitability without diluting the equity base, the prices are likely to move up. However, this long-term up move is likely to be filled with many roller-coaster rides along the way.
 
It is important to learn about the factors causing long term and short term movements in the stock prices and use this knowledge to our advantage.
 
Most other relationships and associations are just coincidences. Such coincidences serve no other purpose than to distract an otherwise disciplined investor, leading to costly mistakes.

- Amit Trivedi

The author is running a knowledge academy. He can be reached at karmayog.knowledge@gmail.com

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