What The "Gambler’s Fallacy" Tells Us About Where The Market Will Go next
By Tyler Durden
Submitted by Nick Colas of Convergex
Viva Las Vegas – The Gambler’s Fallacy
The Dow has closed at a record high for nine days in a row, so it (and U.S. equities generally) MUST be ready for a pullback, right? Not so fast. Thinking that reversion to the mean happens swiftly and reliably is something called “The Gambler’s Fallacy”. To borrow from an old capital markets aphorism, things can stay weird longer than you can stay solvent betting against them.
Today we review a recent academic paper that highlights three examples of this mental error, ranging from judges hearing asylum requests to baseball umpires and bank loan officers. All of them make the same basic mistake in real-life situations despite their professional credentials and experience: assuming that the next decision is somehow linked to the previous one. Umps call marginal strikes after calling a ball, and judges decline refugee status more often after granting the previous person asylum during a day of hearings. The key lesson: every decision you make is unique, and should be unrelated to prior judgements.
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During the summer of 1891, a small time British con man named Charles Wells took a holiday to the south of France. Like many tourists of the day, he frequented the famous casino in Monte Carlo. Unlike many tourists of his day, however, he managed to “Break the bank” – depleting the table where he was playing of all its reserves – several times. He reportedly took home as much as $8 million in today’s money, although his reputation as a swindler both before and after the event left some doubt about whether the whole thing was a publicity stunt.
Fast forward a few years to August 18, 1913, and something equally unexpected occurred: the roulette wheel came up with a black number 26 times in a row. Now, the casino had been in operation for decades by now, so a streaky wheel should not have been terribly remarkable. But instead of taking it stride, the crowds that night bet ever large sums during this run, fully expecting a red number to come up. It finally did, but not before the bank had broken some of the gamblers.
The event gave us term “Monte Carlo fallacy”, which has morphed into the “gambler’s fallacy” since then. Essentially, the cause of the problem is an error in human judgement. We know that random events (the flip of a coin or the spin of a roulette wheel) have certain probabilities. Where we go awry is in thinking that those probabilities will be regularly observable. We think it’s strange when a coin flips HHHHHHHHHT, but if it alternates exactly HTHTHTHTHT that’s OK. In fact, both outcomes have the same probability.
I hear a lot of market commentary lately that strongly resembles what must have transpired across the roulette table in Monaco back in 1913:
- The Dow has hit a new …read more
Source: What The "Gambler’s Fallacy" Tells Us About Where The Market Will Go next
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