Everyone probably assumes that financial decisions are made from the head, and not the heart (yes all decisions are made using the brain, but you know what I mean). Finance and economics is one field which relies heavily on rational decision-making, using positive tools like mathematics, information, data analysis and the concept of ‘wealth maximisation”. Investing in the stock market, selling your shares, borrowing from the bank are some examples of financial decisions you may take in your life and you would probably rely on economics and mathematics to seal your deal. This is a notion that behavioural finance attempts to challenge. You will not always use the rational means of data, information and scientific analysis while making your financial decisions. Financial decisions are not free of the emotional and psychological interferences of the players involved. Behavioural finance combines the knowledge of psychology and economics to explain certain investment anomalies that are seen in real life. It has caused experts to rethink many economic concepts. It has brought into light the importance of human ideas, behaviour and is in stark contrast to the conventional financial theories. In this article, I will be discussing one of the most interesting ideas introduced by behavioural finance: Gambler’s fallacy.
The term ‘Gambler’s fallacy’, itself suggests that it is a form of an anomaly. The term also explains the concept’s origin which is from an observation from a game of roulette (in a casino in Monte Carlo in 1913). If you’ve ever played the game of roulette you already understand the concept, if not the technical jargon. If you haven’t, let’s imagine you are in a casino in Las Vegas or Goa and you are playing the wheel game of roulette.
In your game, the ball has been landing on a red 25 for the past ten chances. In this case, there’s a probability that you will predict that in the next spin, the ball would not land on ‘red’ but on ‘black’. This is because you assume that a ball cannot always land on the red, not after ten times at least and you take a chance that it would land on black. This assumption that a random event, which is not dependent on other variables is less likely to happen after the event or a series of similar events have occurred is Gambler’s fallacy.
It mainly revolves around the illogical concept of any individual that believes that some event(X) which is inherently independent of any other event may be affected by the other event(Y) i.e. even though in reality; logically and rationally X does not affect the outcome or occurrence of Y. Gambler’s fallacy states that people illogical amuse that they do.
Take another example which is widely cited to explain this concept. If a coin is tossed five times and the first four outcomes are- Tail, Head, Head, Head- you are more likely to assume that the fifth outcome is Tail. Now obviously the outcome of the fifth toss has nothing to do with the results in the previous four. If you apply and understand the concept of probability, there is a fifty-fifty chance that the outcome of the fifth toss is either Head or Tail but yet your subconscious may fall into the trap of Gambler’s fallacy. This irrational approach often comes into play because the similarity between random events (like in the similar outcomes of the toss) is wrongly interpreted by an individual (or an investor) as a predictive relationship between them even when there is no relationship between the events.
If you’re clear with the concept, let’s understand how gambler’s fallacy may affect financial decisions taken by investors or other individuals. There are different forms in which Gambler’s fallacy (also referred to as Monte-Carlo fallacy or the Maturity of Chances fallacy) comes into play: Run of Good Luck, Law of Averages, Run of bad luck, etc. All these are based on the fundamental concepts that an individual may make a mistake when analysing random or similar events which are statistically independent.
So if a stock has been doing fairly well on the stock market for a reasonable time, an investor is likely to believe that it would fall. This is a predictable human mistake and the investor would take a call to sell the share sooner than later. If one applies a rational mind, there is no science that suggests that only because a stock has been doing fairly well on the market it would go down in the future. The stock may rise even more in the future but it would be too late for the investor. One way to escape this trap is to understand that stock markets, Gold markets, banks and other financial markets and environments don’t work on emotions, subconscious or your intuitions. They are driven by different economic and social parameters that one needs to consider and analyse while making decisions, but perhaps that becomes too much work.
A study was conducted in the Bombay Stock Exchange to determine whether the professional investors would fall prey to the fallacy and it concluded that the majority of them did. The study also observed that the confidence the investors had in their decision-making also contributed to their biased and irrational decision making. Understanding such concepts of behavioural finance introduces the interesting ways in which the human mind works but it also helps you in making more sound and rational financial decisions.