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.
- Pareidolia describes the tendency to misinterpret patterns as a way of creating order out of chaotic systems.
- For investors—and particularly traders using technical analysis—the misinterpretation of patterns can lead to unwise decisions and devastating losses.
- It is a good idea to supplement technical indicators with fundamental analysis and exit trades quickly if a pattern that you’ve identified turns out to be a misinterpretation.
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.
Pareidolia and the Stock Market
There may be evolutionary advantages to certain forms of pareidolia, but when it comes to the financial markets, misinterpreting randomness as an identifiable pattern can bring negative consequences. Regardless of the rationale you use for your investment decisions, if you are assuming that you have discovered an infallible pattern amid the chaos of the markets, there is a good chance that you’re mistaken.
The dangers of pareidolia in investing are most evident when it comes to technical analysis, which is all about recognizing patterns on stock charts and trading to capitalize on them. One problem with this approach, however, is that technical analysis patterns depict only the stock’s past performance, providing no concrete or actionable information about what may occur in the future.
In addition to the problems with using patterns of past behavior to set expectations about what’s to come, the process of recognizing technical patterns is subject to misinterpretation and pareidolia. For example, one classic technical indicator is a head and shoulders pattern, characterized by three peaks on a chart, with the middle peak (the head) reaching higher than the other two peaks (the shoulders). Traders generally view this as a signal that an uptrend is due for a reversal.
However, even this common pattern is subject to misinterpretation. How precisely must the shoulders match, and how much higher must the head reach, for traders to identify a head and shoulders pattern? Traders often speak of “imperfect” technical patterns, but how closely does a pattern need to match its classic formulation to be considered valid? What is the time frame of the candlestick chart under observation, and how might this affect your expectations of a price reversal?
All these uncertainties point to the danger of being too quick to recognize a technical pattern on a stock chart, potentially acting based on information that is akin to a shape that you’ve imagined in a passing cloud.
Tips for Avoiding Pareidolia
Considering the goal of technical analysis is to identify past patterns to predict future performance, it is possible that the strategy inherently includes some risk of misinterpretation. However, for those who trade based on technical patterns, there are some measures that could help protect against the scourge of pareidolia.
One potential solution is to combine your chart-based trading strategy with an analysis of the underlying fundamentals of the stock you’re considering. If business conditions are positive and there is evidence that the company will achieve future growth, there is a greater chance that taking a long position will play out favorably than if you had bought your shares based on technical indicators alone.
Another idea for dodging the perils of pareidolia is to prepare yourself to exit trades that are not working out as you planned. In general, this means using stop-losses to protect your technical trades. This way, if the pattern you identified turns out to be a mirage, you can exit the trade before racking up devastating losses.
What is the difference between pareidolia and apophenia?
Apophenia is a more general term for the human tendency to recognize patterns or connections between unrelated or random things. This may include auditory phenomena, such as distinguishing words in the din of nonspeech sounds. Pareidolia refers more specifically to visual misinterpretations of patterns, which can occur in everything from clouds to stock charts.
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.
The Bottom Line
Pareidolia refers to the human mind’s tendency to establish meaning and recognize patterns amid what is, in fact, random and chaotic information. This can be harmless and even entertaining when it comes to seeing shapes in the clouds or faces in food items. However, when it comes to analyzing stock charts, this type of misinterpretation can lead to significant losses.