Stock markets are often compared to casinos. For the uninformed investor, investing is like gambling, only with worse odds. Even better-informed investors may be taking more of a gamble than they realise. Like casino-goers, they can fall prey to something called gambler’s fallacy.
What is gambler’s fallacy?
Gambler’s fallacy, also called the Monte Carlo fallacy, is the idea that a winning or losing streak is finite. It has to end at a certain time. However, this idea is not supported by the facts. Statistics say that the outcome and timing of a given end is an unpredictable event.
Think of 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 don’t change. They are still 50/50 for the sixth toss.
But gambler’s fallacy makes people think that the sixth toss will be tails. They think it has to be this way because the previous five tosses all came up heads. This is a guess based on intuition, not a certainty based on statistical probabilities.
Investors with this attitude may see the S&P 500 go up for five days in a row. They assume that day six will end negative. Their instinct is that the streak can’t go on forever, that the odds are in their favour.
Or say the market has been going down for the past six months. They feel that it has to go up in month seven. This idea is not based on solid evidence. It’s based on the feeling that “it’s time” for the market to go up.
What’s the danger?
This bias can be dangerous. Investors shouldn’t make decisions based on the belief that a winning or losing streak “just has to end.” Instead, they should be basing decisions on data or research.
Let’s go back to the S&P 500 example. Let’s say there are good reasons to believe the U.S. markets will continue to stay strong. In that case, it doesn’t matter if S&P 500 has gone up five days in a row, or even five months, or five years, in a row. The winning streak should not even be a factor in the decision. Rising markets can continue to rise, and falling markets can always fall further.
What is confirmation bias?
Gambler’s fallacy and confirmation bias can work together to trick investors into making a bad call. Confirmation bias causes them to look for information that supports what they’re already thinking. It makes them ignore anything that doesn’t fit with their viewpoint.
For example, if they think that the market’s losing streak has to come to an end, they’ll only pay attention to news that confirms their beliefs. They may then make the wrong decision.
Investors can fall prey to gambler’s fallacy when looking at historical trends for a company or market. If this is combined with confirmation bias that backs up their “gut feeling,” they’ll make the wrong decision.
If there is no rational basis for an investment decision, it is by definition a gamble.
How to minimise gambler’s fallacy
One way to minimise gambler’s fallacy is to focus less on past events. Instead, focus 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. Investors buy and sell based on expectations – not on winning or losing streaks, or on what has happened recently.
Stock markets are not casinos. But if investors are not careful, and not aware of their own subconscious biases, they are headed for trouble. They just might end up making more money, or losing less, at the roulette table than in the financial markets.