Today morning I was reading how this fallacy affects the human mind and that it has taken with it many a great stalwarts. I drew some analogies with Stock market trading but more about that later.
On 18th August, 1913 stunned crowds around a roulette in Monte Carlo found a ball landing on the black twenty six times in a row and only on the twenty seventh it landed on the red. By that time many who kept increasing stakes looking for a long overdue red occurrence had lost millions and were already paupers.
This notion feeds on a human perception that there is a “ balancing nature “ somewhere, that if something has been happening more frequently in the past, it will happen less frequently in the future.
Though highly appealing to the human mind, it is false, especially for random, Independent events.
Lets take another example, if one has flipped a fair coin 21 times the probability of 21 heads is 1 in 2,097,152 but if we interpret it rationally, the probability of the next head (or even tail) is simply ½, yes 1/2 only !
Not only people look for a variance, at times a gambler can even take a reverse stand. He may decide that given this consistent tendency towards heads, a head is a more likely an event. He then see’s some mystical correlation and continues betting on heads.
Both of these notions are based on a fallacy that Universe somehow carries a memory of the past results, which tend to favour or disfavor the future outcomes.
Please be sure that the coin or the ball, do not remember that it fell on a black all this while or it flipped head each time and you choosing a Head or a Tail, Black or a Red depends on your personal choice, whether you prefer the first option or the second.
Now lets imagine if you were forced to bet say a 20% of your net worth on the next event, what would you do – Heads or tail , Black or red ? think hard where you stand ?
Now lets stretch it a bit more - Joe and Sam are at the race track betting on horses.
Joe: "You see that horse over there? He lost his last four races. I'm going to bet on him."
Sam: "Why? I think he will probably lose."
Joe: "No way,
Sam. I looked up the horse's stats and he has won half his races in the past two years. Since he has lost three of his last four races, he'll have to win this race. So I'm betting the farm on him."
Sam: "Are you sure?"
Joe: "Of course I'm sure. That pony is due, man...he's due!"
Now lets replace the Race track with Stock market , Horse with say share X and lo ….we get stock market trading !!
You would see people spending hours trying to demystify the trends of individual shares, markets etc. based on what they did yesterday, first hour, after lunch or the last hour, before & after Christmas holidays , how much was bought, what was the price rise and what not. They have raised it to the level of a science, but you can draw your own conclusions based on the foregoing.
When we talk about companies, we talk about their businesses, factories, managements, people, finances, product portfolios , future pipelines, and many other such things, these are all interdependent events.
Only the rigor of detailed analyses & in depth understanding can help reduce the odds and increase predictability.
Thus long term investing is the way forward.
