Like Alex talked about in our last blog, psychology plays a much larger role in our investing habits and choices than we might be inclined to believe. Because we are all human, meaning we are rational and sentient beings, we have the ability to mess things up. What I mean by this is that while we are rational creatures our minds often cause us to make irrational choices and decisions. The study of how psychology commingles with investing is call Behavioral Finance. While not only being very aptly named, the study of Behavioral Finance helps uncover why we make the mistakes we do while investing and it helps explain how to avoid those mistakes. The psychological conundrum we are going to talk about today is called the Gambler’s Fallacy.
Gambler’s fallacy is not simply confined to the realm of finance, but it certainly is an easy trap to fall into. Gambler’s fallacy is the belief that because an outcome has occurred so many times consecutively, the odds of that outcome occurring again have changed, and actually gotten worse. I’ll give the classic probability example and that is flipping a coin. Let’s say you flip a coin 10 times and all 10 times the coin lands on heads. Statistically, the odds of the coin coming up heads 10 times in a row is pretty slim. However, each independent flip has the same odds. So every time you flip a coin you obviously have a 50% chance of getting a heads and a 50% chance of getting a tales, (of course this is not accounting for the extremely slim chance that the coin lands on its side),. The next flip, the 11th, still has the same odds, and is an independent event from the prior 10 flips. You are not any more or less likely to get a heads than you were the previous 10 tosses simply because of the previous outcomes. One who has succumb to Gambler’s fallacy would incorrectly believe that since the last 10 were all heads then there is no way that this next one could be heads too, the odds must have decreased. Well, it may feel that way but statistically the odds are still 50-50.
Gambler’s Fallacy gets its name from the actions of an irrational and addicted gambler. The gambler believes that the more often they lose at the slot machine the closer they are to winning a jackpot. This is not the case as the machines are programmed to give the same probability of a jackpot to each spin, at least they are supposed to. Now that we’ve gone through a Stats 101 refresher, how does this come up in investing?
If a holding has continued to climb over multiple trading sessions, Gambler’s Fallacy says that that holding has to fall at some point, so let’s liquidate and trade out of it. The oversight here is that market movements are independent of each other, and are dependent on many different factors which do not include past results. So, the investor misses out on some gains because they felt like the market had to go down because it can’t go up forever. This can also happen when stocks go red as well. An investment could go sour for weeks, months, and even years while the investor believes they should hold on because they feel like it cannot stay in the negatives forever. The losses incurred pile much higher than they ever should have.
So when it comes to avoiding this mistake when investing, do not confuse your statistics. Events that are independent of each other cannot influence each other. That is irrational. Your decision as to whether to invest in something should be based on fundamental analysis of the stock/fund as well as technical analysis of the market as a whole and the sector the stock/fund is a part of. Do not psych yourself into doing something irrational.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.