Suppose I ask you to flip a coin seven times, and every time it lands on heads. How much would you bet on tails turning up next?
Now suppose you’re a loan officer at the bank. You’ve just granted two loans in a row and it’s not even lunch time. Are you more or less likely to grant a loan to the next candidate?
Or you’re a baseball umpire who’s called two strikes in a row. If the next pitch questionable, will you call a ball or a strike?
We’re all hard wired with a behaviour called “gambler’s fallacy” – it’s the mistaken belief that a random outcome is more likely after observing a previous event. A recent paper by economists Daniel Chen, Tobias Moskowitz and Kelly Shue found that loan officers were 5% to 8% less likely to approve a loan if they had approved the previous application. They also found that umpires were 1.3% less likely to call a strike if the previous two pitches were also called strikes. While those numbers may seem small, imagine this effect over thousands of loans or pitches. It means hundreds of decisions are going the wrong way.
Gambler’s fallacy turns up all over investing too. Some investors hold losing stocks because they believe they’re finally “due” for a bounce. Or maybe a great company is sold too early because an investor believes it can’t possibly get any better. The truth is, investors without a defined, unemotional, and rules-based process are deeply affected by gambler’s fallacy and like the loan officer or umpire, will make their fair share of preventable money mistakes.
A final note, neither experience nor will education reduce the error. It turns out the loan officers in the study had an average of 10 years’ experience, and a separate 2001 study shows gambler’s fallacy turning up among highly trained physicians. When it comes to investing, process is everything.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.