Stock markets are often compared to casinos… and for people who don’t know what they’re doing, investing is gambling, only with worse odds. But even people who know at least something about investing may be taking more of a gamble than they realize – because, like casino-goers, they can be guilty of gambler’s fallacy.
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.
Think of betting on a coin toss. The odds of the coin coming up heads are 50/50 – if the coin comes up heads 5 tosses in a row, the odds for the sixth toss being heads are still 50/50. But 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 not based on statistical probabilities.
Investors with this attitude will see the S&P 500 go up for five days in a row and assume that day 6 will end negative – because the streak can’t go on forever. Or if the market has been going down for the past six months, it has to go up in month seven even if there no solid evidence to support this idea, and 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.
Going back to the S&P 500 example, 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 streak should not be a factor in your decision at all. Rising markets can continue to rise… and falling markets can always fall further.
Gambler’s fallacy and confirmation bias can together trick investors into making a bad call. 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. And then make what may be the wrong decision.
An investor can fall prey to gambler’s fallacy when looking at historical trends or numbers for a company or market – if this is combined with confirmation bias to back up his “gut feel,” he’ll make the wrong decision. If there is no rational basis for an investment decision, it is by definition, a gamble.
One way to minimize 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.
Of course, stock markets are not casinos. But if investors are not careful, and not aware of their own subconscious biases, they just might end up making more money, or losing less, at the roulette table than in the financial markets.