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The Gambler’s Fallacy

The Gambler’s Fallacy

30 Jan 2020

In Fyodor Dostoevsky’s classic novella, The Gambler, central character Alexei Ivanovich at one point studies a roulette wheel and observes the frequency in which the ball lands in a red or black slot.

The more often there appears to be a run favouring the black slots, the more he is convinced that chance will surely favour a gamble on red. After all, it’s now red’s ‘turn’ and he becomes convinced that his bet in this direction will win.

This is a classic example of how the gambler’s fallacy affects behaviour. Yet, mathematically, it is utterly fallacious.

We are not talking of gambling alone here, because the fallacy is just as applicable in investing as it is in wagering.

Caravaggio's 'The Card Sharps' (c 1594)

Mathematicians began to intensely study the odds of winning and losing at cards at around the time Caravaggio painted his masterpiece, The Card Sharps (pictured).

They broadened their research across all forms of betting and, in the course of doing so, uncovered what has become known as the gambler’s fallacy. Here is another illustration of the fallacy in action. If you have a ‘true’ coin and you flip it, the chance of heads or tails coming up is exactly 50 per cent. Now, suppose you flip it 21 times and it comes up heads each time, the odds of that happening are 1 in over 2 million; but then suppose that you flip it 20 times and get heads each time, what are the odds that the coin will come up heads on the 21st spin? The answer is 50 per cent (because a coin has no memory).

Yet most people would wager that after 20 spins with the same result, it must surely now be highly likely that it’s the time for tails to be favoured?

The answer is no, because that reasoning is mathematically fallacious.

What does this have to do with investing? Everything, because many an investor may assume that because the market as a whole – or a single share – has been rising that it must inevitably go into reverse; similarly, when the market eventually corrects (in regressing to the mean at some point, it will likely overshoot) then it would be smart to bet on it rising again because it’s how things ‘work’. Wrong.

This is the reasoning of a gambler, not an investor. The stock market is far more complex than either cards or coins; it certainly carries its own type of risks and rewards. However, risks can be mitigated by ensuring that whoever is managing them has done intensive research by constructing portfolios that sensitively reflect the mindset of the investor.

This is precisely what happens at Palmers. The team there comprises people high in both quality and integrity – they are extremely good at mathematics, too.

Disclaimer & General Advice Warning

This publication has been prepared by Joseph Palmer & Sons (ABN 29 548 490 818) an Australian Financial Services Licensee (AFSL 247067). Whilst the information contained in this publication has been prepared with all reasonable care from sources, which Joseph Palmer & Sons believes are reliable, no responsibility or liability is accepted by Joseph Palmer & Sons for any errors or omissions or misstatements however caused. Any opinions, forecasts or recommendations reflects the judgment and assumptions of Joseph Palmer & Sons as at the date of publication and may change without notice. Joseph Palmer & Sons, their officers, agents and employees exclude all liability whatsoever, in negligence or otherwise, for any loss or damage relating to this document to the full extent permitted by law. This publication is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Any securities recommendation contained in this publication is unsolicited general information only. Joseph Palmer & Sons are not aware that any recipient intends to rely on this publication and are not aware of the manner in which a recipient intends to use it. In preparing our information, it is not possible to take into consideration the investment objectives, financial situation or particular needs of any individual recipient. Investors must obtain individual financial advice from their investment advisor to determine whether recommendations contained in this publication are appropriate to their personal investment objectives, financial situation or particular needs before acting on any such recommendations.

Author: Eddie Lees

Categories: Palmer Blog, Behavioural Finance

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