Markets – whether they’re for stocks, cryptos (especially), Picassos, Beanie babies, or pre-war chewing gum wrappers – have a lot in common with gambling… especially for people who don’t know what they’re doing.
Losing is a lot easier than winning.
But even people who know at least something about investing may be taking more of a gamble than they realise… Like people standing at slot machines, investors can be guilty of the gambler’s fallacy.
The chances of six consecutive heads
The gambler’s fallacy (also called the Monte Carlo fallacy) is the belief that a winning streak, or losing streak, will come to an end at a particular time – even if statistics say the outcome (and timing of the end) is a totally random event.
Imagine betting on a coin toss. The odds of the coin coming up heads are 50/50. Even if the coin comes up heads five tosses in a row, the odds for the sixth toss being heads are still 50/50.
But the gambler’s fallacy causes people to think the odds are better that the sixth toss will be tails – because the previous five all came up heads.
This is an intuitive guess. But it’s not based on statistical probabilities.
The chances that you’ll get six consecutive tosses coming up heads are a lot lower than 50/50 (there’s actually a 1.6 percent chance that you’ll get six consecutive heads, or tails).
But there’s still a 50 percent chance that any given toss will result in heads (or tails).
In other words, betting on the outcome of a coin toss is ALWAYS a gamble.
When markets are on a “streak”
Investors who don’t quite understand this will see the S&P 500 go up for five days in a row and assume that day six will end negative.
They’re certain that the streak can’t go on forever.
Or, if the market has been going down for the past six months, they think that it has to go up in month seven – even if there no solid evidence to support this idea – just because “it’s time” for the market to go up.
This bias becomes dangerous when investors make decisions based on their belief that a winning, or losing, streak might end – rather than based on data or research.
Now… markets aren’t random, like a coin toss. But there’s no particular reason to think that mean reversion will kick in at that particular time.
If there are good reasons to believe that U.S. markets will continue to stay strong based on solid fundamentals, it doesn’t matter if the S&P 500 has gone up five days in a row… or even five months, or five years, in a row. The winning or losing streak should not be a factor in your decision at all. Rising markets can continue to rise. Likewise, falling markets can always fall further.
Then, there’s confirmation bias
Confirmation bias causes us to look for information that supports what we’re already thinking and ignore anything that doesn’t fit with our viewpoint.
So, if we think that the market’s winning or losing streak has to come to an end, we’ll only pay attention to news that confirms our beliefs.
An investor can fall prey to the gambler’s fallacy when looking at historical trends or numbers for a company or market – if he combines that with confirmation bias to back up his “gut feeling,” he’ll make the wrong decision.
If there is no rational basis for an investment decision, it is by definition, a gamble.
How to overcome gambler’s fallacy and confirmation bias
One way to minimise the gambler’s fallacy is to focus less on past events and more on what the data suggests will happen in the future.
Past trends can sometimes provide insight into a current situation, but you need more information than that to make an investment decision.
Financial markets are forward-looking and investors buy and sell on expectations – not on winning or losing streaks, or on what happened recently or yesterday.
And as for confirmation bias, the first step is to recognise that it exists and that your brain is programming you to confirm your own biases.
Then, diversify the sources of your investment insight.
Be sure to consume information that challenges your current beliefs.
Of course, stock markets aren’t gaming dens. But if you’re not careful, and not aware of your own subconscious biases, you just might end up making more money, or losing less, at the roulette table than in the financial markets.
Publisher, Stansberry Churchouse Research
*This has been a guest post by Stansberry Churchouse Research*