1, 2, 3, _ ? What is next?

March 22, 2015

1, 2, 3, _ ? What’s the next number in the series?

When you were about 4 years old, do you remember guessing what the next shape in a pattern was going to be? My 2 young daughters were watching Sesame Street a few days ago, and Cookie Monster was asking them to guess what came next. “Banana, Apple, Banana, Apple, Banana, ____?”

 

All our lives, we’ve been taught to spot patterns and guess what would come next. But as I have grown older, I have learned that guessing what happens next is not as easy as I thought it.

 

Going back to the first question, if you answered 4, you’re not 100% correct. 4 is the correct answer to one of the possibilities. There are an infinite number of possibilities.

 

Have I gone nuts? Give me a chance to explain.

 

4 is the answer to the series IF the series is sequential. While there is a high probability that the series is sequential, there are also other possibilities.

 

Another possibility is that the series could be a series of prime numbers. Do you remember what prime numbers are? If so, the correct answer would be 5. (Math geek note: While 1 is technically not a prime number, the series could be 1, 2, 3, 5, 7, 11, 13 …)

 

One more possibility is that the series could be a part of the Fibonacci sequence illustrated in the diagram below.

Fibonacci

With only 3 preceding data points, there are actually an infinite number of possibilities, such as:

  • 1, 2, 3, 1, 2, 3 …
  • 1, 2, 3, 2, 3, 4 …
  • 1, 2, 3, -1, -2, -3 …
  • 1, 2, 3, 3, 2, 1 …
  • 1, 2, 3, A, B, C …
  • 1, 2, 3, 6, 5, 4 …

Okay you proved your point hotshot, so what? Why is this important and how can I relate this to real life and investing?

 

We are programmed to look for patterns. The brain is designed to think 1, 2, 3, 4. But what if the series isn’t sequential? What if the dots we have connected aren’t the right ones?

 

Since the 17th century, there have been several outbreaks of yellow fever in some parts of the world. People infected with the disease could incur fever, chills, nausea, head and back pain, loss of appetite, and in rare cases, liver damage, bleeding, and even death. No one knew the exact cause for yellow fever for over 200 years. People hypothesized that yellow fever was spread through human contact. It was only until August 27, 1900 when Dr. James Carroll disproved the previous hypothesis by allowing himself to be bitten by a mosquito carrying the virus.

 

Here’s another example. As early as 300 BC, it was theorized that the solar system revolved around the Earth. It was not until after 1500 AD that Copernicus theorized that the Sun was the center of the solar system.

 

From criminology, sports, medicine, science, psychology to business and investing, guessing what comes next from the wrong pattern will give you an incorrect answer that could have disastrous consequences.

 

Do you remember the Internet and real estate bubbles? In investing, bubbles are formed when market participants incorrectly extrapolate limited data into the future. In other words, they think that just because Internet stocks or home prices have gone up in the last year or two, they think it will go up forever (or at least for a while). This is called “recency bias”. Of course the converse is true too. When the bubble bursts and stock prices are going down, the market tends to panic and think that stocks will continue going down for a reasonable period of time.

 

In investing, the future is filled with an infinite number of possibilities. You must make yourself aware of these possibilities (or at least the ones with the most likely outcomes), use a decision tree methodology, and select the best risk-adjusted returns that will give you the highest chance of meeting your objective.

 

In economics, most theories are very logical and sound. The only problem with these theories is the assumption of holding multiple variables constant, while only changing one or a few variables. You can’t assume that in real life. One of my economics teachers once said, “The answer to everything is IT DEPENDS.”

 

So what comes next after 1, 2, 3, _? It depends!

 

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