Way back in the summer of 1913, the Monte Carlo casino in Monaco saw an event that was unprecedented. Gamblers at the roulette wheel saw the ball falling in the black 26 times one after the other while they betted that it would fall in the red.
Many of the gamblers lost a lot of money betting that the ball would fall in the red and not black.
This gave rise to something called The “Gambler’s fallacy” in behavioral finance which means that if outcomes of expected behaviours are not in line with a person’s expectations and if such unexpected outcome is repeated continuously, then the human mind is led to believe that future outcomes will happen in the opposite.
What has this got to do with your financial planning ?
It’s elementary, Watson !
More often than not, your emotions override your rational thinking. And when it comes to personal finance, thinking from the heart and not the head can cause heart attacks.
Take this test of coin tossing for example (This example has been used and abused everywhere that I could not help adding to the misery!).
Supposed you toss a coin 5 times in the air and barring the first which is a tail, the next three are all heads. So the first four tosses go like this – Tail, Head, Head, Head, ?
The question is – when you toss the coin the fifth time, what would come, head or tail ?
What did you answer ? Tails, right ?
That is exactly what most of the people taking this test would do. The Gambler’s fallacy comes into play here and makes you think that the next outcome will be opposite of what has already been happening (3 heads in a row).
If you think for a moment and with a wee bit of elementary mathematics, probability theory suggests that the last toss of the coin is independent of the first four. So the answer can be either head or tail. Both have equal chances of showing up !
If you find this hard to imagine, try it out yourself. In fact, do something better. Depending on which IPL team you support, write down whether your favourite team will win or lose and why before a match is played. You will see yourself going back to check the team’s performance in the last few matches and you will realize that you are rooting for a loss if they have won continuously, or vice versa. Try it. It’s fun !
How does this affect your personal finance ?
The stock market is a perfect place to make a 3 hour Bollywood movie on how players are driven by the emotions of greed, fear, excitement and irrational exuberance (thank you Alan Greenspan). This is also the place where your mind tells you that something new will happen if an event is unfolding continuously in one direction.
So say, you have a stock that is rising for many days now. The human mind is led to believe that it will fall. Blame it on this theory but most investors would think that and take a call that would go against them. They would then lose some money.
Stock markets and particularly stocks in general never go with your and my emotions – they are driven by fundamental analysis of the performance of the company in question. Investors can still use technical analysis to take a call on where the stock is headed in the short term, but your best bet would still be fundamental analysis.
But that is more work ! The expectation of greed to make a quick buck along with this fallacy that the stock will perform opposite to what it has been doing in the past makes one take a wrong call.
The same is even true of a stock that is going down in performance for days and weeks. Your mind forces you to think that now that it has gone down so much, it has only one way to go, which is up. You jump in, buy truck loads of the ticker with your hard earned money only to see it going down again. You then reason that it will eventually go up and average out your losses by buying more trucks of the stock. At the end, your backyard is loaded with trucks that have no fuel to go anywhere !
I don’t think emotional thinking is going to get us anywhere with investing. It’s got to be zeroed down to fundamental and technical analysis in case of stock picking.
Have you ever been a victim of the ”Gambler’s fallacy” in behavioral finance ?