The Hidden Dangers of The Gambler’s Effect in Investing
In 1913, at the famous Monte Carlo Casino, black came up an astonishing fifteen times in a row on the roulette wheel. Thinking that red was “bound to happen” next because of this freak occurrence, gamblers rushed in to bet against the wheel landing on black again. Twenty seven spins later, the casino was millions of dollars better off, and a hoard of gamblers was sorely disappointed because they mistakenly thought there was a higher chance of the wheel landing on red next.
The cognitive bias that occurred here is aptly named The Monte Carlo Fallacy – or the Gambler’s Effect – and it isn’t limited to gamblers. While most statistics are extremely straightforward, our minds’ interpretations of them often aren’t.
For instance, in the case of the casino, there’s roughly a 50-50 chance of the ball stopping on either red or black (with a few other “green” slots typically on the wheel), and each sequence has no effect on the one before – the odds always stay the same. Thanks to this bias, however, our minds are led to think that if a sequence continues to happen, it drastically changes the odds in the future.
The gambler’s effect can also become extremely costly in investing as well. Its main effect is that investors start to see patterns and odds that don’t actually exist. Often, concentrated market bets and poor performance are the results.
It’s impossible to predict with certainty how the stock market will perform in short-term. However, when patterns repeat – such as a stock going up a few days in a row – investors are fooled into thinking that performance is likely to continue.
Look no further than recent stock market history. An investor who looked at the double-digit performance of emerging-market stocks from 2005 to 2007 might have deduced that 2008 would have been a great year to put everything into this market. To say the very least, this investor would have been disappointed to see a -53.2% drop in this market. The moral of this story is that a short-term decision based on a trend can have major consequences.
At LexION Capital, we ignore short-sighted perspectives and so-called hot streaks when it comes to investing. Instead, we can take a data-driven and analytical approach that’s firmly grounded in academic research that can focus on long-term investment strategies for you.
If you’d like to learn more about our rational approach to investing, please contact us today.