Gambler's Fallacy - What Are The Odds?

Let's play a game. I flipped a coin five times. Five times in a row it came up tails. All you have to do is predict what the next flip will be. What's your guess?

Gambler's Fallacy

It's very easy for humans to fall for something called gambler's fallacy. This is a situation in which we know the odds of something, we spot a pattern that doesn't fit the odds, and we think that there must be a reversion in order for the odds to get back to where we think they should be. If we flipped a coin a billion times, about half a billion flips should be heads and half a billion flips should be tails. So if we see five tails in a row and we know that it has to be 50/50, then heads needs to catch up.

This isn't how it works, though. The probability of any given flip is 50/50. It is very possible that we can see tails a hundred times in a row. The coin doesn't know what happened in the last flip.

What's Going On?

Our brains naturally want to seek out patterns, order, and meaning. This happens even when there are no patterns. We need to feel like we are in control; we trick ourselves. For example, let's call heads "H" and tails "T". We view six coin flips showing HTHTTH as more likely than HHHTTT because the second outcome does not appear random to us and we know coin flips are supposed to be random. It is also an easy pattern to recognize and we like that. We don't like to see an outcome like HHHHTH because this doesn't appear to represent the fairness of the coin. In reality, all of these outcomes are equally likely. It doesn't feel that way to us, though.

Can A Rat Outsmart Us?

Many studies have been done about this, but one popular one put rats in front of two lights, a green one and a red one. If the rat correctly chose which light would come on next it would get a treat. The lights went on at random but were set so that the green one came on about 75% of the time and the red one 25% of the time. The rats didn't take long to figure this out and always chose green; they were right 75% of the time. When humans took the same test, we could have chosen green and taken our 75% shot each time, but our brains don't like that. Our brains seek patterns so we would notice green come on six times in a row and think red was due, or we would think we spotted a pattern. As a result, humans were right only about 60% of the time! Remember, this is compared to rats who were right 75% of the time.

Investment Implications

We make more mistakes when we see patterns that aren't there than missing patterns that are there. When we look for patterns in the price of a company stock or the stock markets in general, we tend to make big mistakes. Many people forget that stock prices (and any other publicly traded assets) are random. Some even claim to be able to see patterns that others can't and they'll claim to be able to time the markets, or get in before up markets and get out before down markets. This is nothing more than our own mind playing tricks on us. Recognize that there are things that are unpredictable and you will make far fewer mistakes and be well on your way to making smart decisions with your money.

Bottom Line?

Don't try to time the markets. Don't sell something just because the price went up a few days in a row. Don't look for patterns in random data. Focus on what you can control (like your savings, spending, and investment mix) and don't fret about things that are out of your control.