Imagine this scenario: you’ve just flipped a coin in the air 10 times, and somehow, all 10 flips came up heads. Now, if you were asked to say which side, heads or tails, had a higher probability of coming up on the 11th flip, what would you say? If you’re like most people, you would immediately respond that tails was more likely on the next flip.
But you’d be wrong!
The probability of getting either heads or tails on the 1th flip is exactly 50%, just as it was on the previous 10 flips. The results of the first 10 flips have absolutely no bearing on the result of the 11th flip. In fact, even if you were to flip a coin 1,000 times and get heads each and every time (however unlikely this scenario may be), the flipping history would still have no effect on the probability of the outcome of the next flip (assuming that the coin is evenly weighted).
This extremely common failure in logic is called the gamblers’ fallacy, and it is defined as the mistaken belief that if something happens more frequently during a certain period, it will happen less frequently in the future; or conversely, that if something happens less frequently during some period, it will happen more frequently in the future.
Yet, it is erroneous to believe that an independent event is more or less likely to occur because of independent events that preceded it.
Most of us have fallen victim to this cognitive bias at one time or another, whether with coin flips, dice rolls, or other activities in which chance plays a role. Anytime we see a significant deviation from the distribution of outcomes that we expect, we automatically think that outcomes should shift the other direction in order to “even out” the distribution.
While it is unquestioned that we should expect to see a certain distribution of outcomes over many attempts (coin flips, dice rolls, etc.), it does not preclude the possibility of large deviations from the expected outcome distribution.
The gamblers’ fallacy is prevalent in the investing world. It is common for investors to assume that the market or a stock will go down (up) after an extended period of upward (downward) movement, simply because “it’s about time.”
But, as demonstrated many times in financial history, this logic is flawed and can lead investors to buy or sell positions with no good rationale. Of course, this is not to say that extended periods of upward or downward movement should not be considered when making investment decisions, as such movement can cause a stock to become over- or under-valued on a fundamental basis and lead to a deserved re-pricing.
No doubt reversion of valuations to the mean is a powerful force in the financial markets, but the simple fact that a stock has seen several up or down days (or weeks, or months) in a row should not, on its own, affect the probability of seeing a move in the opposite direction in the days ahead.
As investors, we must combat our tendency to miscalculate probabilities by relying on fundamentals, not price movement. Valuations matter for securities, and price moves can affect valuations, but price moves are, by themselves, irrelevant. As we’ve demonstrated, major deviations from expected distributions of outcomes are not only possible but common, especially in financial markets.
Therefore it is imperative that we remain focused on fundamentals and valuations, not price moves, as by doing the latter we cease to be investors and simply become gamblers.