What Goes up Must Come Down? A Myth That Hurts Investors
How the Gambler's Fallacy impacts your money
If you've ever spent 10 minutes at a roulette table, you've probably seen the following scenario play out:
A gambler is trying to decide whether to put their money on Red or Black. They look at the electronic sign that shows what numbers have recently hit. They see that the last four numbers were all "Black," so they bet their money on Red because they believe "red is overdue."
Then the little white ball lands on "15-Black," and they lose their money.
"What are the odds!?" the gambler says in amazement.
The odds of landing on Red were exactly 47.37%, as there are 38 total numbers on a roulette table, and only 18 are red. The odds of landing on Red would be exactly 47.37%, even if the last 500 spins landed on black.
This false belief that "red was overdue" because the previous four spins landed on black is a textbook example of a cognitive bias known as The Gambler's Fallacy, which describes how people believe the previous history of that random event influences the probability of a random event occurring in the future.
In this post, I highlight how The Gambler's Fallacy can lead to poor investment decisions and how it highlights that the most important financial skill you can develop is grade-school math.
Why people hate randomness
By definition, a random event is unpredictable, and most people are evolutionarily hardwired to avoid unpredictable events.1 This causes us to apply an easy-to-understand explanation to try and make sense of unpredictable events.
The mind looks for patterns in the recent history of a random event—say, whether the roulette ball lands on red or black—to predict what will happen in the future. In our attempt to rationalize a chaotic world, we often apply a simple (and wrong) narrative to explain the unexplainable.
In their groundbreaking 1974 paper titled “Judgment under Uncertainty: Heuristics and Biases,” Amos Tversky and Daniel Kahneman detail how our minds fail to comprehend random events.
First, most people—even highly educated people—don’t understand how statistics and probability work. Tversky and Kahneman noted that people have an “Insensitivity to sample size.” This means people tend to put the same amount of faith in a small sample size as they do in a large sample size—when, in reality, the larger the sample size, the more likely it is to reflect the total population.
The second is that many people view random events as self-correcting, meaning we expect random events to return to mean immediately. Returning to the roulette example, the gambler thinks “red is due” to come up because the last four spins landed on black, except the roulette ball doesn't know that it’s expected to land on red and black at the same rate.
To quote Tversky and Kahneman:
“Chance is commonly viewed as a self-correcting process in which a deviation in one direction induces a deviation in the opposite direction to restore the equilibrium. In fact, deviations are not "corrected" as a chance process unfolds, they are merely diluted.”
Both of these reasons we fail to process random events also highlight the widespread lack of numeracy, which refers to a person's ability to understand basic math such as percentages and probability.
As I have written in the past, people with low numeracy are less likely to participate in workplace retirement plans, invest in stocks, or even own a home, all of which are classic pillars of wealth creation. They are also more likely to miss their mortgage payments and other bill payments.
Being unable to understand the reliability of large vs. small sample sizes and that random events are not self-correcting are also symptoms of low levels of numeracy.
A lack of understanding of math and probability is a contributing cause of the Gambler’s Fallacy.
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The Gambler’s Fallacy and why stock picking is so hard
Past research has shown how the Gambler’s Fallacy makes it difficult for stock pickers to outperform the market.
In short, the Gambler’s Fallacy leads stock pickers to underperform by selling a hot stock too soon and hanging onto a poorly performing stock too long.
Imagine you buy a stock because it has been increasing rapidly in value. You own it for 3-4 months, and the stock continues to skyrocket during that time. You think, “this can’t continue; the stock is due to come back down in value.” So, you sell the stock only to discover that it continued skyrocketing after you sold it.
The reverse situation is also common. An investor buys a stock because it’s decreased in value recently, and they believe “it’s due to rebound,” and when it does, they will ride that stock to enormous profits. So, they buy the stock only to watch it continue to lose value day by day.
Both are common examples of the Gambler’s Fallacy and even more evidence as to why investing in index funds is a more rational approach than picking stocks.
It’s important to note that the Gambler’s Fallacy does not apply only to novice investors. A 2006 study found evidence that the Gambler’s fallacy impacted highly educated investors.
Even index investors are not immune to the Gambler’s Fallacy. When the stock market reaches a new all-time high, it’s common for investors to start selling stocks because they believe the market is “due for a correction.” In chapter 27 of The Rational Investor, I review the evidence of why that is a mistake.
When the stock market researches a new all-time high, we are more likely to see new records than a market crash. Research has shown that investors who invested only on days when the market set a new all-time record outperformed investors who invested on randomly selected days.
The Gambler’s Fallacy tells us that “what goes up must come down, and the higher the starting point, the harder the fall.” While we tend to remember the extreme cases where this is true, more often than not, what goes up, continues going up.
So, how do you avoid the impacts of the Gambler’s Fallacy as an investor?
Diversify your investments and buy and hold.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.
Stevenson, H. H., & Moldoveanu, M. C. (1995, July 1). The Power of Predictability. Harvard Business Review. https://hbr.org/1995/07/the-power-of-predictability
This is really fascinating. I’m not a gambler, I’m not even an investor (yet?) because I know I don’t understand about probabilities, random repetitions or any of the other stuff you write about here. Knowing what I don’t know has kept me out of trouble, I suppose. But I would like to be able to invest someday. Or at least feel I had enough of an understanding that I could invest if I wanted to. I think your last line about buying & holding puts me off because I’m an older person. I should just use my money now! Watching it increase over 3 or 4 decades isn’t appealing since I may not be here to reap the rewards. But super conservative investing isn’t all that appealing - may not even be investing pee se. Bonds seem rather dull. Sigh. Anyway great piece, I really enjoyed this. I hope you write much more about it.