Bright lights, constant noise, flowing drinks, and cheers of celebration punctuated by groans of defeat – welcome to the casino! I am not an avid gambler, but my wife and I have been to a number of casinos together and with friends. As my interest in behavioral finance grows, I realize that the casino industry has had us humans figured out for years – there is a reason the “house always wins”.
What is the Gambler’s Fallacy?
The Gambler’s Fallacy, is a cognitive bias in which an individual believes that a certain event is more or less likely to occur based on previous events or the outcome of a series of events. Casino’s are well aware of this bias and exploit it. Below are 3 common tactics:
- Using streaky games: Games such as roulette and craps have a significant element of chance, and players may see patterns in the outcomes. Casinos will often highlight these patterns to players, encouraging them to believe that a particular outcome is more or less likely to occur based on past results.
- Using near-misses: Slot machines are programmed to have near-misses, where the player almost wins but just misses out. These near-misses can create the illusion of a pattern, encouraging the player to believe that a win is more likely to occur soon.
- Using non-random sequences: Some games, such as baccarat and blackjack, use non-random card sequences, which can create the illusion of patterns and influence the player’s betting decisions.
I recall vividly picking a roulette table based on the number of black or red hits in a row, believing that the opposite color was certainly due to hit and selecting this table would put me at an advantage. The casino laughs all the way to the bank and I head back to my hotel room with a much lighter wallet.
How the Gambler’s Fallacy Impacts Investors
In investing, the Gambler’s Fallacy can manifest in the belief that a stock or market will change direction based on past performance.
The Gambler’s Fallacy expresses itself in a number of ways within financial markets, including:
- Chasing hot stocks: If an investor believes that a stock’s past performance is an indicator of its future performance, they may be more likely to invest in a stock that has had a recent string of positive returns, even if the stock is overvalued.
- Anchoring: The tendency to rely too heavily on the first piece of information encountered when making decisions. Investors who are anchored to a stock’s previous price may make decisions based on that price, rather than on the stock’s fundamentals or current market conditions.
- Trend-following: Investors may follow trends in the market, believing that past trends will continue into the future. This can lead to buying high and selling low, rather than buying low and selling high.
- Herding behavior: Herding behavior is the tendency to make decisions based on the actions of others, rather than on one’s own research and analysis. Investors who exhibit herding behavior may make investment decisions based on what they believe other investors are doing, rather than on the fundamentals of the stock or market.
How can an investor avoid falling victim to the Gambler’s Fallacy?
- Conducting thorough research: One of the best ways to avoid the Gambler’s Fallacy is to conduct thorough research and analysis of a stock or market before making an investment. This includes analyzing the stock’s fundamentals, as well as its historical performance and current market conditions.
- Having a well-diversified portfolio: Diversifying one’s portfolio across different asset classes, sectors, and geographic regions can help to reduce the risk of being affected by the Gambler’s Fallacy. By not putting all eggs in one basket, investors are less likely to fall for the illusion of patterns in a specific stock or market.
- Sticking to a well-defined investment strategy: Having a well-defined investment strategy and sticking to it can help an investor to avoid the Gambler’s Fallacy. This includes having a plan for entry and exit points, and not deviating from it due to short term fluctuations.
- Being patient: Patience is key when it comes to investing. It’s essential to not to get caught up in short term fluctuations or the illusion of patterns, and to focus on the long-term objective.
- Seeking professional advice: If an investor is unsure about how to avoid the Gambler’s Fallacy, they may want to seek professional advice from a financial advisor. They can provide guidance and help to ensure that investments are being made based on facts and fundamentals, rather than on past outcomes.
In short, the Gambler’s Fallacy in investing is the mistaken belief that the future outcome of an investment is influenced by past outcomes. Investors should base their decisions on facts and fundamentals instead of past outcomes.
There are so many psychological quirks, biases, and shortcuts that humans use which have very real implications for our financial lives. While many of the cognitive shortcuts we use are essential to survival, they don’t always align with what is needed for a long term investment plan. After all, for the majority of humanity’s time on earth we were all much more focused on surviving the night and finding the next meal, not on getting our 401(k) account to $1 million before age 60. Pattern recognition is certainly an important cognitive requirement and was probably pretty important for human survival over the millenia, but as behavioral economist Dr. Daniel Crosby says there is a difference between the world of Wall Street and everywhere else. The gambler’s fallacy is a reminder that some of the behaviors we are conditioned for in the world, simply don’t hold true in the financial world.
In my view, both market timers and roulette players have one thing in common – a chance at being right, but a larger chance at being wrong. The house always wins – whether it’s the Belaggio or the NYSE.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
This content not reviewed by FINRA
Northbrook Financial is an Investment Adviser registered with the State of Maryland. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy or the completeness of any description of securities, markets or developments mentioned. Please contact us at 410-941-9709 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate or modify any restrictions on the management of the account. Our current disclosure brochure, Form ADV Part 2, is available upon request, and on our website https://www.northbrookfinancial.com