Sunday, September 27, 2009

Behavioural Finance Part 5 - Gambler’s Fallacy

After a long hiatus, it’s time to get back to discussing the interesting and volatile aspects of human behaviour, and how this influences our decision-making processes concerning our investments and money. Behavioural Finance is a growing field and incorporates principles of human psychology to see how it influences the way we perceive and handle money. Interestingly, I had always noticed that one of the more intriguing aspects of human behaviour concerns gambling, as noted by occasional news reports of casino or lottery winners; and also of gamblers having to pawn and sell all their belongings just to avoid bankruptcy. This is in addition to the almost total collapse of the “victim’s” family and social support, as his gambling addiction totally destroys all aspects of his life.

From an investing perspective, I would like to introduce what is called the “Gambler’s Fallacy”. Essentially, by definition this refers to a person’s view that since a random event has occurred with a certain regularity or in a certain perceived pattern, this would immediately indicate that this pattern or trend is unlikely to continue in the future. This is incorrect because random events are considered independent events in probability theory and have no correlation or causative effects on another random event. Yet, people tend to associate both events together and make deductions or conclusions based on the frequency or probability of occurrence of the second event. This works both ways in investing to the investor’s disadvantage – when the price of a stock (note: NOT its value) is going up in consecutive sessions, an investor has the urge and tendency to sell because he believes the trend will not continue. Conversely, if the stock price has gone down a few consecutive trading days, an investor may also tend to hold on longer than he should as he believes the trend will “break”. This is akin to flipping a coin 20 times and getting “heads” every single time, thus you expect that on the 21st flip, it would have to come out “tails” because it was heads for 20 times already! Of course, one can clearly see the flaw in logic in this example as each coin toss result is independent of all other coin tosses.

When a person observes the price of a counter and does not focus on the value of a company, he will be subject to Gambler’s Fallacy all the time. By studiously going through a company’s newsflow, fundamentals and financials, one can make a more informed decision of the actions he should take with regards to an investment which are not prejudicial to his own interests. Instead of relying on price actions to guide his decisions, one can make more astute decisions by treating stocks as part ownership of businesses and making a business decision instead. One will then cease to be classified as a “gambler” (i.e. speculator) and become an investor.

Interestingly, I had noted the gamblers’ mentality when I recently assisted a friend to purchase some 4-D and Toto tickets (the Singapore version of lottery tickets). Most of them consist of blue collar workers and retirees who stake anything from a few dollars to a few hundred dollars buying numbers in a certain sequence and hope for a windfall gain. Others (usually strapping young men) also engage in legal soccer betting through Singapore Pools by studying the odds on a big LCD monitor and then placing their bets at the counter. Most of these folk, I am sure, are totally clueless about the exact probability of winning the top prize (or any prize, for that matter!). It has been said that a reward quantum should be based on magnitude of reward, as well as probability of achieving that reward. To give an example, if the probability that I will win $100 in 50%, that means the reward quantum is $50 (50% of $100). In a lottery, the probability can go down to as low as one in ten million (yes, it’s 10,000,000 with eight zeroes!), and the top prize is probably about $1,000,000. So this means the reward quantum is about $0.10 (1 million divided by 10 million) – not a very attractive proposition and certainly nothing to salivate at! But the problem here is people’s expectation of that great big reward which keeps them punting and returning to try their luck, irregardless of how many times they fail to hit the jackpot.

I once asked this friend of mine why he spent so much (tens of dollars at a time, twice a week) on punting. He said he was “investing” in lottery and he wanted to make a windfall gain. My natural reaction that was to ask if he had kept track of every single transaction in an Excel spreadsheet and tracked his “ROI”. He looked blank for a while but then confidently asserted that he must have “made money” over the long-haul, because he remembers hitting the top 3 prizes (for 4-D) a few times, so he should have recouped all his capital and more. The problem with this line of thinking is that your “winners” will pervade your thoughts more than the countless number of times you had “lost” money (i.e. not won the lottery). This is also why traders and investors tend to remember their winners rather than their losers, and so kid themselves into thinking they made a pile of money while not accounting for their realized (and unrealised) losses! The right way to go about this is to document every single trade (yes, including fees) over time and to compile it over an extended period (3-5 years minimum) to see if one consistently can generate a decent return on investment. I am currently doing so myself to remain objective and to remind myself that I have “losers” as well as “winners”.

The same thing happens at casinos, which I feel compelled to comment on now that the IR in Singapore is almost close to completion. Casinos play on many behavioural aspects of human beings and thus act as a “trap”; in fact there is little entertainment value (go play a computer game) and is hardly suitable for money-making (try investing in an ETF instead), yet there are hardcore casino players (called “high-rollers”) who spend millions and burn their money away till some are bankrupt. Take the most notorious case of a certain Chia Teck Leng, a former APB Finance Manager who swindled about S$117 million (over 4 years) from several banks – the money was not for altruistic reasons like helping African children to buy more food, in fact it was to feed his insatiable addiction to casino gambling!

So to end off, one should always be wary of gambler’s fallacy, as well as the dangers of problem gambling. A little punting here and there on soccer betting is probably harmless, but if one gets obsessed with winning and starts to stake higher and higher amounts then it will spiral into a huge problem, and will end up a disaster in the making.

19 comments:

Createwealth8888 said...

http://createwealth8888.blogspot.com/2009/09/gambling-investment-speculation.html

See the differences.

Musicwhiz said...

Hi createwealth8888,

I was actually aware of the difference between pure gambling and intelligent speculation, but was hoping someone would point it out in the comments. I am glad you did make a comparison.

I have knowledge of people who make intelligent bets when the odds are strongly in their favour - this counts as speculation but there is an element of probability present which works in favour of the bettor. So I guess we must reakky weight our risk/reward ratio before proceeding.

Cheers,
Musicwhiz

Keat said...

Sometimes people buy Toto is in hope of a "black swan event" (of hitting the jackpot).
Its sort of like buying a cheap call option with very high upside?
The casino or Singapore Pools selling u the option of which they definitely on a net-net basis earn more premium than actual paid-out event.

JW said...

Hi MW,

there's one portion I don't fully agree.

"By studiously going through a company’s newsflow, fundamentals and financials, one can make a more informed decision of the actions he should take with regards to an investment which are not prejudicial to his own interests. Instead of relying on price actions to guide his decisions, one can make more astute decisions by treating stocks as part ownership of businesses and making a business decision instead."

One can also make use of price actions to guide one's decision. The key is whether one is sufficiently trained to do so (i.e. TA). To me, your post was a little too biased against TA.

Be it TA or FA, as long as one did not do it studiously, one is speculating/gambling.

And be it TA or FA, both are done with the aim of increasing your odds of succeeding in buying the share. Informed decisions can be made by either camp.

Let's focus on FA since yours is a FA blog ;) Even having calculated the value of the stock, and buying because of it, you are still making an intelligent bet just like TA. Reasons being:
(i) value traps as you have mentioned before
(ii) analysis of profitability could be wrong, and hence value could drop.

No offence ok? Just sharing of thoughts :)

Lastly, although I know you are a pure FA person (I tried to start out this way too), I would like to introduce you to the idea of Elliott Wave Theory, and it's applications to socionomics and behavioural finance as well. To me, it's a theory that's part FA part TA, and it's very very interesting. Do take a look :)

simon said...

seriously guys, a lot of you are hardcore FA ppl. could someone kindly tell me how do i find out a company's cash burn rate from the company's financial statements?

simon said...

seriously guys, a lot of you are hardcore FA ppl. could someone kindly tell me how do i find out a company's cash burn rate from the company's financial statements?

donmihaihai said...

hi simon,

If there are lot hardcore FA ppl and no one is helping you then either they are all selfish or you should self help rather than asking around. Or maybe there arn't lot of hardcore FA ppl around.

Anyway as far as I know, there isn't any rigid model to extract "cash burn rate" from financial statements.

Cash burn rate usually refer to start-ups that are not generating enough revenues to cover all expenses. For more mature companies where revenues is way > expenses then this does not apply. But if you are looking at the amount of "fixed expenses" a company must bare if it is to keep as an operating entity, then it can be done but that required not just the knowledge of accounting, finance but understanding of the company and the industry. It vary from company to company.

simon said...

hi donmihaihai,

thx for the explanation. very helpful!
btw, since there's no rigid model, and to simplify things a little, do you think using the operating expenses in the p&l (e.g. admin expenses, selling expenses etc.) would still give a good picture of the cash burn rate per year for the company? in my opinion, i would think so because it would roughly represent the amount of cash that has to be paid out each year. I would like your (or others) opinion on this.

simon

Musicwhiz said...

Hi Keat,

Haha point noted. Everyone is hoping for their own "Black Swan", and in the end Singapore Pools is the only one getting richer. Hehe.

Cheers,
Musicwhiz

Musicwhiz said...

Hi JW,

No offense taken, but yes my post was definitely biased towards TA, and I make no bones about it. I know there are probably 99% of people out there who either believe in TA, or use some form of TA combined with FA. But I choose to invest purely based on a company's fundamentals and prospects, and will not rely on historical price charts or trendlines at all.

Although you may argue this method "deprives" me of better gains, there is no conclusive proof this can work well for me (it's a personal issue). Thus far, using FA alone, I have been getting a decent return on my investment.

As for value traps and the possibility of being wrong, yes of course FA cannot eliminate the probability totally, but what you can do is to understand the economics of the company and over the long-term, the merits of the company will shine through and ensure your downside is much lower than your potential upside. That's the bet that investors make, I guess.

Btw, good comment! I really liked it. :)

Thanks,
Musicwhiz

Musicwhiz said...

Hi Simon,

Sorry if my reply was a little late. I am sure there are FA people out there who are willing to help, but this is not an easy question to answer, so let me try.

Cash burn rate is tied to the amount of cash a company uses in excess of what it receives. That is 1 definition. Another is the rate of cash usage by the company. I would think exact figures are hard to obtain unless you are working in the Finance Dept of the company!

You can get some hints from the Cashflow statement, but the actual cash burn rate is usually just an estimate.

Donmihaihai has also given good guidance on cash burn rate too, kudos to him.

Cheers,
Musicwhiz

JW said...

Hi MW,

"Although you may argue this method "deprives" me of better gains, there is no conclusive proof this can work well for me (it's a personal issue)."

I have to say I agree fully with this. One should stick with a style that one is most comfortable with :) TA might just now work for you, so I won't go further on that. This is something I realised quite recently on my foray into this new arena.

Anyway, I've only just embarked on my investment/trading path (<1 yr). Still lots more to learn :)

A university honours degree requires 4 years of our life to complete, but this journey will take much longer than 4 years.

Cheers!

Musicwhiz said...

Hi JW,

Yes, in fact investing is a journey of a lifetime ! We should grow and enjoy it as we move along through this fantastic voyage. For if one learns to invest properly, the rewards at the end of the journey are bountiful!

Cheers,
Musicwhiz

Createwealth8888 said...

http://createwealth8888.blogspot.com/2009/09/find-your-perfect-pitch.html

Limit your journey to 5-7 years and see where are you getting to and change course if necessary.

dsea said...

Hi Keat,



TOTO are pari-mutuel games. In which, Singapore pools is just the "totalisator", ie., the admin chap that collects the bets from all of us, annouce the winnig number, deduct the admin expenses and pay out the winnings. Not exactly a call option for the participant.

The closest analogy would be the participating fund of an life fund insurance company, preferably a mutual insurance company, where its run for benefit of policy holders.

For 4D, Singapore pools do practice position limit. Note that they do refuse to sell 4D when they hit their position limit.

PanzerGrenadier said...

Hi MW

Another interesting post which is worthy of publication in Business Times IMHO.

Even Temasek and GIC time the market (although Tony Tan kept saying only this "once") with their bets on US financials despite their public position of being "long-term" investors.

How long-term can one get when you buy/sell the same company within 1 year?

Even Sovereign Wealth Funds can fall prey to the Gambler's Fallacy, i.e. when global equities go up, they say it's because of their astute value investing for long-term. But when subprime fiasco occurs, they conveniently blame external factors (beyond their control).

In the meantime, GIC/Temasek chaps are not poorly remunerated especially at the top echelons.

I think we sometimes get too fixated about dogma when it comes to investment philosophies, i.e. FA vs TA. To me, do you make $ or not using whatever approach that is aligned to your own risk/reward trade-off tramework.

I agree that tracking gains/losses are important and I've been tracking since 2003. It may not be 100% accurate but it's 95%+ and gives me a very good idea whether I've employed the capital (personal investible net worth) of Panzer Pte Ltd effectively, beating 2 x fixed deposit returns.

Be well and prosper.

Musicwhiz said...

Hi Createwealth8888,

Why did you use 5-7 years as your time frame? Is there any particular significance to this?

Thanks,
Musicwhiz

Musicwhiz said...

Hi dsea,

Yes, I think they flag those out as "red numbers" and refuse to sell anymore to people. This is to limit their liability in case that number turns out to be the first prize! They use probabilistic computations to arrive at the optimal number they should sell to maximise their own profits.

Cheers,
Musicwhiz

Musicwhiz said...

Hi Panzer,

You are indeed too kind haha, I am just articulating some of my thoughts. Thanks for your kind compliment.

I think as investors/traders, we should keep detailed records in order not to mislead ourselves that we are doing far better or worse than we think we are.

SWFs like GIC and Temasek can of course say as they wish, but ultimately it's long-term performance that counts. They can use whatever method they wish - they are a black box anyway and it's as good as viewing them as a hedge fund as they are not transparent enough with their disclosures to Singaporeans.

I've always felt that a purist approach works better for me, rather than try to meld the best of both worlds of TA and FA to achieve a hybrid successful mix. I am comfortable with what I do and how I do it, and though I will modify my strategies and criteria as I go along, it will be along the lines of value investing (and not related to TA).

Cheers !
Musicwhiz