Setting the Scene – A Gambling Analogy
Let’s say you’re at a casino, playing roulette. You’ve placed your bet on red 5 times so far, with no luck. What is your next move?
Victims of the Gambler’s Fallacy would choose to bet on red again. Why? Because they think that they are “due” a red. The roulette wheel has landed on black 5 times already – thus increasing the chances of it landing on red. Right?
Wrong. Each time the roulette wheel is spun, there is a 50% chance of it landing on red or black. Outcomes of prior circumstances do not influence future outcomes of random chance events. This is because things like roulette wheels or coin flips are all independent events. Previous events have absolutely no bearing on their results. It doesn’t matter if the roulette wheel landed on black 100, 200, or 500 times in a row. It will not increase the chances of it landing on red next. There will always be a 50-50 chance of the result being red or black.
The Gambler’s Fallacy – aptly named due to its prevalence in the casino scene – is an important concept for everyone, especially investors, to understand and avoid. Many a gambler has fallen prey to this fallacy, whether it be at roulette or a slots machine. These gamblers are squandering away their money to use towards ungrounded beliefs, and investors can easily fall into this trap as well.
The Law of Large Numbers, Explained
Part of the Gambler’s Fallacy stems from a misunderstanding and misinterpretation of the Law of Large Numbers. This law states that the average of the results obtained from a large number of trials will tend towards their expected value.
However, one must note that the actual results will not immediately reflect the expected value. Flipping a coin twice will not necessitate one head and one tail. Even flipping a coin 100 or 10,000 times will not yield an exact 50-50.
John Edmund Kerrich famously flipped a coin 10,000 times while a prisoner of war during the Nazi occupation. His results? 5,067 heads and 4,933 tails. Increasing the number of coin flips will get you closer to achieving the expected / theoretical result, but it will only approach it – not accomplish it.
How This Factors Into Investing
The Gambler’s Fallacy applies to investing, much as it does to gambling. For example, just because a stock’s value has risen over the past few months does not mean that it is due for a dip anytime soon.
Here are some tips for avoiding the Gambler’s Fallacy:
1. Maximization
You can use the Law of Large Numbers to your advantage. Practice portfolio diversification to maximize the number of securities held. Maximize the days of market exposure to use the strategy of time diversification.
This way, regardless of the ups and downs that are inevitable in the stock market, you would get closer to achieving the expected returns.
2. Data, Data, Data
Base your decisions on technical analysis and concrete data evidence instead of relying on personal judgment calls. Take the time to objectively analyze all sources before making an investment decision. Learning to survey the stock market landscape without letting anything cloud your judgment is an important skill to learn, and it is what makes a successful investor.
3. Look Forward
Investors should be making decisions with a forward-looking approach. The financial market is based on future expectations, rather than on current trends. Sometimes the past can provide insight on these expectations, but it is better to remain focused on what data can suggest about future occurrences.
Now that you are aware of the Gambler’s Fallacy, what are some examples of times that you unknowingly committed this cognitive error? How do you think you can avoid this in the future?
Want more brain food? Learn more about Behaviorism and how it affects us when investing.