Gambler’s fallacy: the odds are lying to you
- We’re primed for patterns but be careful not to spot them where they don’t exist
- Our brains are lazy and instinctive, we need to help them make better decisions under pressure
- Taking your emotional self out of the picture could be the best investment process you ever put in place
The value of your investments and the income you receive from them can go up and down, and you may get back less than you invest. Any examples are for illustration purposes only.
You’ve sidled up to the roulette table and just before you plant your chips down you notice a screen showing the past nine consecutive spins have landed on red. Do you:
- Think this table must be stuck on repeat and go for red?
- Think that surely, with that amount of red, the next one has to be black?
- Ignore it all and choose the colour you already had in your head?
If you went for the third option, well done - you’re permitted one celebratory fist-pump.
Read more:
How to pick ‘forever’ stocks
How to value stock (without losing your mind)
Anchoring: when bias weighs on your returns
As tempting as it is to read into all the previous rounds’ results and either lean into the apparent pattern or predict a reversal, the reality is each new spin starts afresh. The table has no memory even if you do.
The real question, though, is why that screen is there in the first place.
Investors are emotional creatures
We’re quite a simple lot. In the absence of fact or reason, we’ll naturally try to find some sort of logic to cling to, especially when it comes to making decisions under pressure. We want some sort of basis to work from, to trust in through the process and to blame if things go wrong. The thing is, our brains are what behavioural economists call ‘cognitive misers’ meaning they will preserve energy by being lazy. That means we’ll often find ourselves opting for the shortcut, the option we understand easily, or the one that’s shoved in front of us - notice that none of these take into account which one we actually believe to be correct.
So, even with no logical basis for the casino’s spin screen, it’s there to give us some semblance of order and control to keep us betting even though, deep down, we know it’s all just chance.
By now, the crossover with how we emotional animals can sometimes approach the stock market should be coming through. With 24/7 market news constantly flashing stock tickers, social media accounts touting the ‘top three stocks to make you rich’ and Lambo-topped grifters selling trading courses, the shortcut economy has never been so healthy.
How do we make sure we don’t fall victim to behavioural bias and the gambler’s fallacy, then?
Your best bet? Get out of the casino
The thing about behavioural biases is that, if we knew when we were falling victim to them, we’d just recognise them and stop. That’s not how they work though. As calm under pressure as we think we are, throw money into the mix and those mental shortcuts won’t be long in popping up. A pumping pulse can take control and leave us thinking what on earth we were doing, afterwards.
It’s why preparation is vital. In the quiet times, make sure you have processes in place to limit how much opportunity the Jekyll in you has when investment decisions come up. A post-it note with a checklist of attributes you’d expect to see in a stock is much better than trying to read market tea leaves from a share price graph.
Read more:
Six things to do before you start investing
How to spot a pump and dump scheme
Five investing myths
You might even keep a spreadsheet that will colourcode company valuations and highlight any that slip into your buy criteria. Or what about a notebook recording the reasons you bought the stock, along with possible reasons you’d sell it.
A simple exercise I learnt is to conduct an investment pre-mortem. Before you buy a stock, ask yourself what you’d do if it dropped by 50%. Better than that, think about what is likely to have caused that fall and if there are signs of that already in the business. The point here is prevent palpitation-induced decisions if things go awry - you already know what you want to do as you already foresaw it happening.
In a practical sense, have a think about limit orders that kick in when your defined buy or sell levels are breached. Automating the whole process means you won’t slip into trying to make sense of short-term movements and can rely on pure logic carrying out your process.
In the end, if mental shortcuts are becoming a part of your investment decisions, it’s time to get back to basics, remind yourself of your own research and mitigate those bad habits before they eat into your returns.
Important information
When investing, your capital is at risk. The value of your investments, and the income you receive from them, can go down as well as up and you may get back less than you invest. Forecasts aren’t a reliable guide to future results or returns.
Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information and does not constitute any financial advice. This is not an offer, recommendation, inducement or invitation to buy, sell, or hold any securities, or to engage in any investment activity or strategy.
