This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 8 October 2016.
Imagine you are a finalist at the World Championship of Coin Tossing. Your goal is not to toss the coin higher or further than anyone else; rather, you just need to correctly guess what the result of the next coin toss will be. The rules of the game are reasonably simple: the coin gets tossed five times and you need to correctly call the sixth toss. If you get it wrong, your only solace is a Mad Monday celebration with the other losers. Get it right however, and you get to stay awake partying for five days straight and even appear on the national news, complete with the obligatory sunglasses and husky voice. Or something like that. Anyway, back to the action. The coin gets tossed five times and amazingly comes up heads five times in a row. Your entire coin-toss calling career now depends on correctly calling the next toss; what’s it going to be? Heads or Tails? Given that the coin has landed heads side up five times in a row, you may be thinking that the next toss is more likely to be a tail than a head, right? Wrong, it’s still a 50:50 call. The fact that the coin has landed on a head the previous five times is completely irrelevant to the potential outcome of the next toss. The coin has no idea it just landed on heads five times in a row – the outcome of the next toss is always going to be 50:50 between a head or a tail. Even if the coin landed on heads 100 times in a row the probability of the next toss being a tail is still no more than 50%.
Welcome to The Gambler’s Fallacy. Not the latest release by Kenny Rogers, but rather, a behavioural trait in humans where we expect a sequence of random events to have an influence on the outcome of the next random event in the sequence. Keen followers of roulette are particularly prone to The Gambler’s Fallacy, erroneously believing that certain numbers are more likely to come up than others, or that patterns can be discerned in what are only random events. Related to this is the Hot Hand Fallacy. Not a Nick Cave single, but the incorrect belief that streaks of ‘luck’ can be divined in what are essentially random events. By now, you’re probably asking yourself, what’s the link to finance? Well, in essence, short term movements in share prices are effectively random events, but that doesn’t stop people from trying to discern patterns where none exist. The truth is, short term share trading is nothing but guesswork. In the longer term, company fundamentals such as revenue and profits are the true drivers. My advice: forget the gambling and focus on the fundamentals.