Gambler’s fallacy in a world of uncertainty

Gamblers-FallacyGambler’s fallacy is a term we often hear.  What is it exactly and how does it affect what you do with your money?

It is the belief that future events will be shaped by past events, even when the two have no correlation.  A gambler will assume a coin is due to come up heads after flipping a string of tails, but the outcome of the next fair coin flip is completely independent of the last one—the odds are still 50/50!

Coins have no memory.

Investors fall for a version of gambler’s fallacy when they assume things like economic data, quarterly earnings, and politics will dictate the direction of the market when in reality the three often move independent of each other.  Randomness is hard to accept, but a fact of life on this planet.

randomness

Why?  Because human nature likes order.  No matter what the law of chance might tell us, we search for patterns among random events wherever they might occur.  We are insensitive to probability.

A fascinating study showed that if people think they are going to win in a lottery, their bets and their expectations about the chances of winning are likely similar whether the probability is 1 in 10,000 or 1 in 10 million.  If people feel they are going to win, they can be willing to pay up to 1,000 times more for the same lottery odds!

What is going on here is that gamblers are more moved by the possibility, rather than the probability, of a strong positive consequence.  If the potential outcome of a gamble is emotionally powerful, its attractiveness (or unattractiveness) is relatively insensitive to changes in probability as great as 1000-fold.  The result is that very small probabilities carry great weight.

Be aware that the Gambler’s fallacy is a deep-seated cognitive bias and therefore very difficult to eliminate.  Sadly, even educating ourselves about the nature of randomness has not proven effective in reducing or eliminating any manifestation of the gambler’s fallacy.

One thought could help though: Before you make a decision, treat the series of events that led you to that decision as if each event is a beginning, and not a continuation of previous events.

Statistics aren’t that useful either in that regard.  Ok, statistics are useful for calculating “risks” — say, a game with unknown outcomes but known ex-ante probability distributions.

It’s the reason the House always wins in the end in any casino.

But statistics are not useful for “uncertainty” — calculating outcomes in situations with an infinite number of unpredictable outcomes.

In other words, statistics are terrific when limited to what happens in gambling halls.

But it is a huge mistake to apply them to the world of financial markets and the economy.

During the last Financial Crisis for example: Fannie Mae, Lehman Brothers and AIG leaders all thought they were operating in the world of “risk.”  Instead, they were operating in a world of “uncertainty.”

The bottom line?

Take any statistic you read with a grain of salt.  Chances are it is made up, will be revised or is just plain misapplied.

We really know much less about the world than we think we do.Black Swan Events

We do know, however, that we must not disregard probability when making financial decisions.  Always anticipate and prepare for Black Swan Events.

But do not overweight small probabilities either, because this would just increase the attractiveness of those lottery gambles again.

Now it is up to you.  Did this post provide some good food for thought or did it totally confuse you?  Let me know below …

“Men resist randomness, markets resist prophecy.” — Maggie Mahar 

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