Investors like to believe they make rational decisions based on available data. Do they really though? We know from experience that humans are far from completely rational beings. People get emotional and make mistakes all the time. There’s also a large number of cognitive biases we have to contend with.
Psychologists have been studying these issues for decades, and have discovered a long list of cognitive biases which affect human decision making.
I’ve written about a few of these cognitive biases in the past (most notably the Dunning-Kruger Effect), but I’d like to touch on one particular cognitive bias today — A variant of The Gamblers Fallacy.
The Gamblers Fallacy
Imagine for a moment you flip a coin seven times. Each time the coin lands heads-up. For most people, this would seem like a very unlikely outcome. Based on the previous coin tosses, the flipper may believe that the next coin toss is far more likely to be ‘tails’. This is what’s known as the Gamblers Fallacy.
In reality, the probability of a head or tails on the next coin toss is equally as likely on the first or seventh coin toss.
This is (of course) assuming a fair coin toss — one not biased to either outcome (heads or tails). In this scenario the coin flipper believes it’s a fair coin.
At first glance this might not seem particularly relevant to investing, you’d be surprised how often I hear people say, “The stock market has been positive for 5 years in a row. We’re due for a pullback soon. Start taking some profits now.”
In other words, because we’ve seen [X] successive years of positive results from the stock market, investors believe we’re more likely to have negative performance the following year.
This is a classic example of the Gamblers Fallacy applied to the stock market.
The Unfair Coin
But what if the coin toss wasn’t fair? Since we don’t know whether the coin is fair or not, after seven successive tosses the coin flipper may decide that the coin is weighted unfairly, and it will flip heads every time. In other words, data from the previous flips directs us to believe the next toss will be heavily weighted towards ‘heads’.
This change in behavior happens when the flipper believes that the coin isn’t fair.
When it comes to the stock market, the probability of a stock rising or falling is completely unknown to us. Essentially it’s an “unfair coin” to use terminology from the Gamblers Fallacy.
On any given day we don’t know the probability of whether a stock will rise or fall. The outcome is essentially random for all intents and purposes.
In cases like these, our human brains begin to believe that past results can tell us what to expect in the future. It’s a mental “rule of thumb” that human brains default to when we don’t have enough data to predict a future outcome.
Investors do this all the time. We see past results and use it to predict a future outcome. This may or may not be an accurate prediction of the future.
I’m sure you’ve heard the saying, “past performance is not indicative of future results.” It’s written at the beginning of every mutual fund prospectus… yet we’ve all done it at some point.
Humans look at the data, see a pattern, and then extend that pattern out into the future.
Common real-world examples of this behavior:
- Stock investors see a pattern of a hot stock rising, so they buy-in, believing the stock will continue to rise.
- Bitcoin investors see gigantic gains in bitcoin price charts, so they believe they’ll see large gains in the future.
- Real estate investors observe that a ‘house flipping’ is a successful strategy . They believe this strategy will work well in the future.
- Index investors have seen excellent results in recent years, so they believe the future will continue to have similar results.
Investing like this is incredibly dangerous, because Mr. Market provides essentially random outcomes in the short term.
A stock can continue to go ‘up’ for years despite earning very little money (Tesla anyone?). Or, the stock could do nothing for a decade. This non-performance can happen despite the fact a stock continues to grow earnings and shareholder value.
Microsoft stock is the perfect example of this in the real world:
The lesson learned here should be: Markets rarely create linear outcomes that can be easily predicted with past data.
Stop Looking At Past Results!
Looking at past results is a difficult habit to break. Trust me, it’s taken me years to get to the point where I don’t even look at a stock chart to make buy/sell decisions.
Instead, I’ve learned instead to focus on other kinds of data that are not rearview mirror looking — like earnings yield, the business drivers, shared value economics, the ability of the CEO to compound capital, executive incentives, and so on.
Why are those metrics important? They drive future value creation. Just remember the classic investing maxim, “In the short-term the stock market is a voting machine. In the long-run it’s a weighing machine”.
In the short-term the outcome of capital markets can be completely random, but in the long-term it’s the ability of that asset to build value that will drive the price.
This is exactly why purchase price matters. If you buy a stock when it’s outrageously overvalued, it could be years or maybe even a decade until the underlying value of the stock catches up to it’s price. Could you really hold onto a stock for a decade without seeing price gains?
For many novice investors (used to buying “at any price”), this concept can be difficult to grasp. Price and value often seem like the same thing. They are not. It doesn’t matter if it’s a stock, bonds, index funds, real estate, or even a bitcoin — Don’t let past results trick you into believing the future will be just as rosy as that 5-year chart.
Cognitive biases can be tricky to overcome, but defeating them is just one more step on the path to becoming a truly rational investor. This doesn’t mean you’ll no longer make cognitive mistakes (it’s still entirely possible). The point is to reduce these errors in judgement.
We all make mistakes, but truly rational decision making will help you become a better investor (and less of a gambler).
It’s this distinction between investing and gambling that illustrates the point — Gamblers hope the price will go up. Rational investors buy assets without “hoping” they’ll go up, they already know they will.
Even then, mistakes are still entirely possible. Black swan events like COVID-19 can completely throw the world out of whack. Lost decades do indeed happen. A rational investor simply has more tools with which to protect him/herself from these unpleasant outcomes.
The real world is, after-all, more than just a coin-flip. Why not weight the odds in your favor?
[Image Credit: Flickr]