Why Investors Do The Crazy Things They Do – Concept 4 Gambler’s Fallacy

This is the fourth article in this series where I discussed a concept called behavioral finance. It’s a relatively new field that tries to combine behavioral psychology theory and economics and finance to explain why people make irrational financial decisions.

We’ve covered three concepts, Anchoring, Mental Accounting, Confirmation and Hindsight Biases, and now Gambler’s Fallacy. These are psychological mistakes we all make. Hopefully with a little awareness, you’ll know you’re doing it.

Concept 4. Gambler’s Fallacy
This concept is one of my favorites. Well, maybe the word favorite is not what I mean! I recognize this one very often. With the Gambler’s Fallacy, an investor falsely believes that past events will affect future events. An example would be flipping a coin 10 times and it lands on heads every time. One might now conclude that the next flip will probably be tails. However, the odds are still 50/50.

Investors are easily seduced by the gambler’s fallacy. Investors falsely believe that if the stock market or a portfolio has increased over a long period of time, that it can’t possibly continue. Therefore, they want to liquidate and go to cash. On the other side, I talked to prospective client one time that had watched her company stock, where she worked for over 30 years, continue to decline from $100 to $30. She felt it was improbable for it to continue so she held on and watched her life savings decline by two-thirds! Just because the stock market or a security has gone up over and over, does not mean it will continue, or vice versa.

How to Avoid Gambler’s Fallacy
You have to remember that the odds are the same for a future event, no matter what happened preceding it. Buying an investment because its trend indicates that it will continue to increase is completely irrational. Base your decisions on fundamentals of the stock or investment.

Coming up next…Herd Behavior and Overconfidence. If you want this series of articles delivered to you automatically, click here for a free subscription and have them in your email inbox every Friday morning!