By ROBIN POWELL
The human brain is a truly wondrous thing. Though weighing only around three pounds, it contains approximately 86 billion neurons and is capable of processing around a billion billion (that’s 1,000,000,000,000,000,000) calculations every second. And yet, strangely enough, there is a simple concept that even this extraordinary organ struggles to understand — randomness.
Why is that? Well, human beings have evolved to dislike uncertainty. We crave predictability. We want to understand the complex world we live in and to feel a sense of control over our own destiny. So we see patterns where none exist; we mistakenly read meaning into entirely random data.
Say, for example, you watch someone flipping a coin. If the coin lands heads up several times in a row, you might think that tails is “due” to come up next. You might, conversely, assume that, because it’s gone on so long, the run of heads is likely to continue. Either way, your thinking would be flawed, because the probability remains exactly 50:50.
Markets are far more complex than we realize
We make the same mistakes when thinking about the stock market. We like to think we understand the market. Even those who accept they don’t understand it nevertheless assume there are very clever people who do and can be trusted with managing their investments.
But the stock market is an immensely complex ecosystem, driven by a multitude of factors including economic indicators, company performance, political events and investor psychology. In fact, it was shown as long ago as 1900 by a French mathematician named Louis Bachelier that, at least in the short term, stock prices move in an entirely random fashion.
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This article is based on the book Index Funds: The 12-Step Program for Active Investors. The issues it raises are addressed in Step 3:
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