Invest
Behavioural Finance Part 5 – Gambler’s Fallacy
By Musicwhiz  •  September 29, 2009
[caption id="attachment_3280" align="alignright" width="150" caption="Photo by conorwithonen"]Photo by conorwithonen[/caption] 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. Read more...
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By Musicwhiz
Musicwhiz who is in his 30s is educated in accounting and works in the investment line (but not in a bank, financial institution, brokerage or fund house). He has a have a full-time job and investing is his side-line as well as passion. Musicwhiz is a value investor and his technique is derived from the teachings of Warren Buffett, Benjamin Graham and Phil Fisher. He incorporate all aspects of their investing style, and modify his value investing style to the Singapore market.
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