Picture the scene. The coin is flipping in the air and it’s your turn to choose heads or tails.
It’s been heads five times in a row up to now, so surely we’re due a tails? As it lands, Queen-side up, you think to yourself, ‘Now it definitely has to be tails.’
A playground scene similar to this was my first real memory of running into what behavioural economists call the gambler’s fallacy. As in my ill-fated example, this particular bias preys upon our inability to separate previous experience from what might happen next.
It tends to flare up when we start to apply our own version of emotion-led probability to what’s about to occur. Another popular example of the gambler’s fallacy in action is at the roulette wheel - black eight times in a row? It must be red next.
Here’s the issue - every time we reset the roulette wheel or shuffle the deck and deal again everything reverts to zero. What’s happened in the past has absolutely no bearing on this brand new situation, so using previous spins to predict the next one is coined in the name: a fallacy.
The relevance of this heuristic won’t be lost on investors going into 2020. The longest bull market in history has brought with it growing scepticism of next year’s market performance but how much of that is based on data-led research? There may be mixed opinions on the trajectory of global growth or corporate earnings but if we let our hunches trump fact we’re falling victim to our innate biases.
Behavioural economics beyond the market
It’s hard for us to completely avoid biases like these because it can feel like we’re applying sensible logic when we aren’t. It doesn’t help when there’s money involved but we’re still susceptible to their effects in other areas of our lives.
Studies have found loan officers can be less likely to approve a perfectly acceptable loan if they did so for the last applicant, as if they’re under pressure to seemingly promote balance. And referees can feel more justified in awarding penalties if they have just turned down a few appeals.
As far as investing goes, there is ample opportunity for us to fall victim to the gambler’s fallacy. We might get sucked into seeing a fund price go up or down for five years in a row and convince ourselves the opposite has to happen next, based on nothing but a feeling. When you start using intuition instead of the facts as a basis for your decisions it’s only a matter of time until emotion is running your whole portfolio.
The remedy here is to recognise these feelings when they appear, and they will appear. It’s natural for us to jump to what we think is logical because our brains are lazy, and we cling to anything that promotes certainty over the unknown. Once we can see these feelings emerge we can remind ourselves that there is no factual basis to what we are considering.
Hear what some investment professionals have to say on the year ahead below:
Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
Source: Quarterly journal of economics, volume 131, issue 3, August 2016.