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 gambler’s fallacy got to do with your financial planning ?
Gambler’s fallacy – 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 Gambler’s fallacy 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 gambler’s 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.
While this theory is very much prevalent in the stock markets, investors are driven by the same logic when they deal with other investment avenues like mutual funds, real estate and even gold.
Have you ever been a victim of the “Gambler’s fallacy” in behavioral finance ?
@TheWealthWisher,
Good analysis, Very true when you mentioned about stock market, its a no less than gambling. I have fallen into this trap. Initially people start making money and the lure to make more pulls you in and before you realize you are already trapped and then there is no way out. I know many people who have committed suicide due to loss in stock market.
I have been tempted to online sports betting too but somehow stayed away.
LOL, sports betting ? !
Nah, its better to go to Las Vegas, you will lose you money there as well but get to see the place too !
@TheWealthWisher,
By sports betting i meant English Premier League, I have been following it for the last 15 years, so i am well-versed with most of the teams. I used to be a regular @ ladbrokers though never did any betting. My friend made few pounds betting on the team suggested by me.
I couldn’t stop smiling through out the article. I have done it all: the gambling, the IPL betting, stock market and all this seemed like a flashback :). If you are doing something repeatedly, after a certain point of time you stop focusing on the fundamental analysis and start deciding on this fallacy.
The whole fallacy is indeed very true and I don’t think there is any person who has not fallen for this fallacy. You question at the end should be “Are you the one who has never fallen to this fallacy?” 😉
Yes Vivek, I think everyone has fallen to this fallacy. That is the working of the human mind, isn’t it. There is no solution to this I am sure and a person’s own learning can correct this fallacy to some extent. I don’t think it is completely curable.
I think that it is evident all the time in stock markets. Markets behave more like a spring. If you pull it gently, it would revert back gently. If you pull it very harshly (more than the normal bandwidth of the spring), it shall to revert to its normal levels violently & quickly. Normal level is decided by the fundamentals, while the movements in spring may be owing to market forces.
I don’t believe that even Warren Buffet would have deceived the fallacy, because if he could, he would have been 100 times much bigger than what he is now. However, where he is right now proves that he has understood the fallacy well enough and has been mostly successful in filtering the emotional aspects of investment decisions !
Exactly, well said BFA.
Thanks.
Very very interesting article (concept)…. If anyone is still fallen into this, then this is the time to think on it and understand.
I think almost every investor when enters into stock market, falls into this. Even I used to think like this when I started checking market, though I have never traded.
I liked the line ‘thinking from the heart and not the head can cause heart attacks’ :).
That’s why SIP wins always, let it be bear or bullish keep investing.
I feel VIP (value based) at some extent can be kind of Gambler’s fallacy (not exactly), as we think market is low, invest more and market can get even lower.
Thanks Chirag, I did not quite understand the VIP thing you mentioned, if you have the time, please do elaborate.
@TheWealthWisher,
A Value averaging Investment Plan (VIP) is an investment strategy that works like an SIP – you invest on a pre determined date, into a fixed mutual fund scheme, achieving the purpose of disciplined investing and following the finance gurus when they say ‘Buy Low’.
But while in an SIP the amount is fixed and units may change, in a VIP you have a target value of your portfolio, which increases by say Rs. x,000 per month, and you invest the difference between the current value of your portfolio, and the targeted portfolio investment value.
For example, suppose you set a target level of Rs. 5,000 per month. You invest for 2 months (Rs. 10,000 invested totally) and the market falls. So the current portfolio value of your Rs. 10,000 invested, is now Rs. 8,500 (it’s in the red). To make up for this fall, you invest Rs. 5,000 for your third month’s investment, and also an additional Rs. 1,500 (Rs. 10,000 minus Rs. 8,500). So in the third month, when the market has fallen, you invest Rs. (5,000 plus 1,500) i.e. Rs. 6,500, instead of Rs. 5,000.
Similarly, if the market has risen, and your Rs. 10,000 has grown to Rs. 12,000, then when the time comes to make your third month’s investment, you will not invest Rs. 5,000, but instead Rs. 3,000 (Rs. 5,000 minus Rs. 2,000 – the profit you have made due to the market rise). In essence, the VIP bridges the gap between the target portfolio value, and the actual current portfolio value. It buys less when the markets are high and more when the markets are low.
The benefit of this approach is very apparent:
If the markets go down, you invest more, if the markets go up you invest less. So if there is value to be had, if you can buy on the cheap, value investment plans will help you do this. And if the market rises and investments become ‘expensive’, the value investment plan strategy will ensure you do not invest as much. It might even ask you to redeem some of your investment, booking profits in the process.
By buying more when markets go down, you are also benefiting from rupee cost averaging on the downside. Investing regularly inculcates financial discipline, and again you don’t have to worry about too much paperwork.
One thing you need to keep in mind though is that you need to have sufficient cash flows to meet the investment that will be required in market dips, as at these times, you will be investing more – sometimes much more.
Good explanation Rakesh, I did know about VIP but did not understand in what relation the earlier comment was provided. Thanks for your contributions here.
I think Chirag was trying to say that in anticipation of your money will grow when market is down, you may to tend to keep investing more and more every time market falls.
Yes I was trying to say exactly the same as Vivek guessed.
Say if you start investing when Market at 19K, then after few months market falls and stays around 17K flat till one year you will be investing more and more. Then if next year is still continues to be bad and market falls to 15-16K, your investment value would increase. So during this phase, you don’t have enough budget to invest (as you already invested more last year), it would be a problem and you will even miss an oppotunity to invest in low(est) market.
Sorry Radhey for late reply.
One more thing, I stopped getting emails when someone replies on my comment (since long time), I think due to this I might have missed to reply few of them ;). Is it problem only for me or it’s been off. Good that I came to this article again and saw you guys’ comments :).
@chirag its not just with you, even I am not getting any alerts. I think the feature is disabled.
Thanks Rakesh for explaining VIP in a great deal, very educational.
So, this is something a person will have to track manually or is there any automated system for this as well?
@Vivek,
I guess we will have to track by ourselves but there are few MF which offer VIP though i have never tracked them.
Currently, ICICIdirect has this functionality, it’s called TIP (Target) there. It works similar to VIP. Only thing is it would concentrate on the Target value you selected.
I think pure VIP is just keep investing based on market conditions and stop it when you feel you reached at what you want or you retired ;).
Don’t know about any other VIP tools. It may be possible that fund managers would be using this kind of tools for equity investment, not so sure though.
Thanks Chirag for the useful contributions.