Behave yourself: the gambler’s fallacy

In some casinos there’s a screen beside the roulette table showing what number and colour the previous spins have landed on.

Why?

Well, to help us guess which colour at least will come up next, right? Very un-right. 

But the annoying thing is, it does provoke us into making predictions.

That’s the danger with putting a slurry of numbers and colours in front of human eyes. We’re hard wired to ‘work it out’ and try our best to recognise a pattern.

And we’ll still try to do this when there is simply no possibility of a pattern being found.

Roulette is a classic example from the behavioural economist’s handbook with a very real crossover into how we tend to tackle the markets.

Crucially, it can also teach us how not to approach investing.

So, let’s look at what buttons the casino-owners are trying to push to take our money from us.

First, that screen is there to help the casino, not you. It gives a false sense that there’s some sort of probability at play. There isn’t.

Each time the wheel is reset everything starts again, independent of whatever happened before.

So no matter what is on the screen, it has no bearing on what is coming up, except to make you believe there’s some way to work it out.

Never has ‘past performance is no indicator of future returns’ been so accurate.

If it has been red 10 times in a row, there’s nothing to stop it being red again, despite everyone around you saying ‘surely it has to be black this time.’ It has an equal chance of being either.

But, when the broken clock turns out to be right those two times a day, it is at its most perilous. Eventually we will guess right even with those false assumptions.

That can make us think we’ve cracked the code and have the skill to beat the table. So we bet more.

By now the parallels with the market should be coming through.

We can end up looking for signals in the companies we like where there aren’t any. We concoct narratives around stocks and trading patterns that don’t hold up, and we let our emotions run our accounts from time to time.

And this is where it all ties together. There’s money at stake. And not just any money - our money to lose, and all that free money to win.

The fear and hope and greed and excitement create one hell of a drug for our little brains to cope with.

So, it’s normal to want to find an edge, to give us some sort of advantage. The difficulty here is that we’re born with a sense of cognitive laziness. If there’s a shortcut, we’ll take it.

PE ratios? EV/EBITDA? ROCE? Dividend cover? ‘No thanks, I just have a really good feeling about this one…’

We have a tremendous ability to get ourselves into a world of trouble along the way without even noticing it. 

So how do we defeat the gambler’s fallacy?

First of all, do your homework. The smattering of Scrabble letters above are just a few ways to determine if the company you’re looking at is actually going to be right for you. 

They don’t require a maths degree - in fact most of the numbers already exist online, as well as info on how to interpret and use them.

And if choosing individual companies is not for you at the moment, don’t be afraid to look at index funds or ETFs. 

Second, behavioural biases aren’t something we can just switch off. Or else we would have done that by now. 

The instinctive, immediate and emotional reactions we feel when we see a stock plummet or shoot up are governed by what an old colleague used to call our Homer Simpson brain. 

Taking a second to remove ourselves, assess the situation and plan a course of action means tapping into our rational Spock brain - that’s the one we want running the show in this instance.

Have a checklist of things to decide on before you invest. Can you run a pre-mortem with yourself, asking ‘How would I feel if my portfolio dropped by 50%?’ or ‘Have I done the groundwork for this stock, or have I taken a shortcut?’

You wouldn’t believe how many post-its I've seen on the side of analysts’ monitors, with a few quick bullet points they always address before giving stocks a buy or sell rating.

Another important point is to stay open to learning, and stay humble. 

Finding a winner on the market, and the Homer Simpson-brain reactions that can bring, often ends up with us attributing the gain to our skill. And any less successful investments to a bad table/market/coin toss.

Humility and the will to admit when we get it wrong will serve you well in investing.

And lastly, investing should be really quite boring. That emotion in the casino is led by the excitement of possibly getting rich quick.

But excitement breeds rash decisions - jumping in and out of the market, ignoring valuations and investing on a hunch, not admitting you were wrong and doubling down on a dog of a share.

The studies are really quite clear that the person who methodically invests in the index once a month, rain or shine, beats the ones who wait on the side lines, trying to snipe at the market dips.

The reason is compounding - and as boring as that sounds, it’s the force that will snowball your money into something hopefully useful later in life.

So, do your best to recognise when that excitable part of yourself asks to take control of your money, take a step back and come back with Spock in charge.

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Important information

This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.

When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.

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