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Investors: Beware the Gambler’s Fallacy

When you look at the annual returns for the S&P 500 index for the past eight years as displayed in the table below, what do you think are the odds of the S&P 500 earning a positive return in 2017?

Many would predict that the odds are against a positive return in 2017, simply because they think the bull market has lasted too long. Unfortunately, some investors will adjust their portfolios or move out of the market altogether because of this thinking. But when you understand the gambler’s fallacy, you might think twice.

The Gambler’s Fallacy
The gambler’s fallacy is the tendency to over-predict reversals in situations such as coin flips, games of chance and market returns. Hersh Shefrin, professor of behavioral finance at Santa Clara University, explains the gambler’s fallacy using a coin flipping example in a 2007 paper.1 In his explanation, Professor Shefrin points out that many people incorrectly presume the probability of a tail on a sixth coin flip—after five heads in a row—to be greater than the actual probability. This is because they know that roughly half the flips in any long stretch should be tails and they have not seen a tail for a while.

Going back to our initial question about the performance of the S&P 500 in 2017 — did you know that the S&P 500 has a 3 to 1 shot at being positive, irrespective of previous year returns?2 A 3 to 1 shot is really good, but many investors fall prey to the gambler’s fallacy and fear that too many good years in a row indicate a strong chance that a down year is imminent.

The Hot-Hand Fallacy
Another illusion that plagues sports followers and investors alike is the hot-hand fallacy. In sports, the hot-hand fallacy leads to predicting that a player will continue to be hot because his recent performance has been hot, while for investors it is the fallacy that a hot manager or asset class will continue to perform well given recent performance.

More generally, the hot-hand fallacy involves predictions of unwarranted continuation when observing processes that are unknown. The belief that streaks have predictive power is an illusion that can cause investors to make poor decisions.

The chart below shows the 2016 returns for several asset classes. Many experienced double digit returns for 2016 but bonds, US REITs and International Small Stocks ranked at the bottom in returns. Are you going to buy only hot asset classes and avoid cold ones the next time you add money to your account? Or will you remember that just because an asset class performs at the top of the list one year doesn’t mean it won’t be at the bottom of the list the next year?

The gambler’s and hot-hand fallacies plague gamblers, sports fans and investors alike. The eight-year bull market has many investors on edge, wondering if next year will be the year of the bear. Maybe it will and maybe it won’t. But understanding these illusions may help keep you from making unnecessary changes to your long-term plan.

By Sheldon P. McFarland

1Shefrin, Hersh, Behavioral Finance: Biases, Mean-Variance Returns, and Risk Premiums, CFA Institute Conference Proceedings Quarterly, June 2007.
2Since 1926 the S&P has been positive 66 out of 90 years or roughly 75% of the time, which equates to 3 to 1 odds.