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Charts don't lie, but they can apparently be bad influences.
To the litany of ways in which investors can undermine their own performance, add an over-reliance on charts and graphs, according to a University of Western Ontario associate professor.
Take the simple price chart. For many investors, it's the primary tool through which they track markets and individual securities. While those graphs are meant to inform financial decisions, they can actually compel investors to act rashly and irrationally, said Rod Duclos, a behavioural psychologist at UWO's Richard Ivey School of Business.
"Graphic displays of data seem able to bias consumers' evaluation of financial information and, consequently, their investment decisions," he said in a study, published in a recent issue of the Journal of Consumer Psychology.
"Sometimes they can backfire and be harmful to investors."
While he specializes in marketing, Mr. Duclos said he's drawn to the intersection of behavioural psychology and finance. So he decided to test out some long-established cognitive biases in the financial space.
In judging a particular experience, people tend to place more importance on their latest observations. "We rely on the past to predict the future. And the most recent past is often assumed to be more diagnostic than distant past," Mr. Duclos said in an interview.
He suspected that stock price information in chart form may support that bias. "We suggest that lines on a graph instill a greater sense of continuity over time since each new day is visibly and directly linked to its predecessor," the study said. "This sense of continuity may in turn make it easier to expect and/or visualize consistency from one day to the next."
The availability of stock market intelligence to retail investors has resulted in the proliferation of graphical tools designed to make sense of that data. A stock chart, for example, can distill unlimited data points of price performance from which instant readings can be made, and far more easily than by poring through numerical information.
"Stocks, debt, commodities, and foreign-exchange markets can thus be reviewed at a glance, thanks to sophisticated yet user-friendly graphic interfaces," the study said.
But perhaps those quick conclusions promoted by stock charts are not rational ones, he explained.
He had participants examine a chart of the past 30 days of price performance of a hypothetical stock, using randomized data generated around two criteria, price and volatility.
Over the 30 days, the resulting chart showed no discernible upward or downward trend on average. The study's subjects were asked how much money they'd be willing to invest in that stock based on what they saw.
A second group was shown the stock chart's mirror image – same average price, same volatility, same flat trendline, but with opposite day-to-day movements.
A purely rational approach would arrive at a similar investing decision in either case. But the study found that the direction of the stock on the final day of trading had undue sway over decision making. Whether the stock ended the trading period up or down, in fact, influenced participants' investing decisions with a variance of up to 75 per cent, Mr. Duclos said.
"That's huge," he said. "People tend to focus on a couple of instances to form a retrospective average."
When participants were instead shown price performance numerically rather than in chart-form, their investing biases faded.
"It's a pretty efficient way of fixing the bias. But it's not sexy," Mr. Duclos said.
Charts remain a crucial tool in evaluating investments, but this study takes a step in examining how their careless use can lead to bad decisions.
"Don't just rely on graphs," Mr. Duclos said. "Even professional investors, they will take just seconds to review large amounts of data, and commit huge amounts of money."
Tim Shufelt