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.