You may be treating your money like a Las Vegas gambler choosing between red and black on a roulette wheel and not even realize it.
After three spins of black, researchers say, our brains usually expect red to win next even though red and black, on a table played fairly, have the same probability of coming up no matter what was spun before.
That anticipation of red, called Gambler’s Fallacy, lets us overlook the laws of probability and leads us to errors in judgment far beyond casino tables — to our finances and to the high stakes game of life itself.
We can foil the phenomenon if we put our minds to it, Kelly Shue, a University of Chicago assistant professor of finance who researched the effects of Gambler’s Fallacy, told Money Talks News.
“People draw too much from several bad signals in a row that could be just random,” Shue said. If we take time to pause and think, we are less likely to fall prey to Gambler’s Fallacy.
Whether we make decisions about other people, or others make decisions about us, Gambler’s Fallacy touches our lives and is the subject of ongoing studies.
Shue, colleagues Tobias Moskowitz, a University of Chicago finance professor, and Daniel Chen, associate professor of law and economics at ETH Zurich, recently published and updated their findings after studying Gambler’s Fallacy in three real-world scenarios:
- Refugee asylum court decisions: U.S. judges were slightly more likely to reject a current case if they’d approved the previous one. If they’d approved two cases in a row, their likelihood of rejecting the third went up significantly. Judges on the bench longer were less affected by Gambler’s Fallacy.
- Loan application reviews: Loan officers were slightly more likely to reject a quality applicant if they’d just approved one. If they’d approved two in a row, the likelihood of rejecting a third rose. Like the judges, loan officers with more experience were less likely to follow that pattern.
- Baseball umpire calls: Umpires were slightly less likely to call a pitch a strike if the previous pitch was called a strike. When the current pitch was close to the strike zone’s edge, this effect more than doubled. The effect also is significantly larger following two previous calls in the same direction. Because pitches are tracked, their calls could be evaluated. “Put differently, MLB umpires call the same pitches in the exact same location differently depending solely on the sequence of previous calls.”
Although each scenario’s variance because of Gambler’s Fallacy is slight, the results stack up over time.
“The evidence is most consistent with the law of small numbers and the Gambler’s Fallacy — that people underestimate the likelihood of sequential streaks occurring by chance — leading to negatively autocorrelated decisions that result in errors,” the researchers said.
Shue noted the research can apply to anyone in the position of evaluator.
If you’re hiring someone for your company, and you come across three great job candidates in a row, what will you think about the fourth? A teacher grading papers may give out three good marks and mark the fourth down.
“In lab situations, subjects tend to expect reversals,” Shue said.
Outside the lab, you may see the inverse: A craps player claims a hot streak or lottery winners line up at the lucky 7-Eleven that just sold the jackpot-winning ticket.
Neurons quick learners
We’re hardwired to fall for Gambler’s Fallacy, suggests a new study published by researchers from the Texas A&M Health Science Center.
Researchers took a computer model of biological neurons and trained it with random sequences, officials said. They found that by simply observing a coin being tossed repeatedly, the neurons could learn to differentiate and react to different patterns of heads and tails. The neurons that preferred alternating patterns such as head-tail significantly outnumbered the neurons that preferred repeating patterns such as head-head.”In other words, these neurons behaved just like the gamblers in a casino,” principal investigator Yanlong Sun, assistant professor of microbial pathogenesis and immunology at the Texas A&M Health Science Center College of Medicine, said in a prepared statement. “When the outcome of a fair coin toss is a head, they are more likely to predict that the following toss will be a tail than to predict it will be a head, despite the fact that either pattern is equally probable.”
The coin toss test is the best way to “break up expectations of reversal,” Shue said.
Flip a coin 20 times, and you may see appearances of eight heads in a row; flip it a thousand, you’ll likely see about 500 heads and 500 tails total, no matter how many times each showed up many times in a row.
The financial foil
“Time lag is the main disruptor of Gambler’s Fallacy,” Shue said.
In penny-flipping experiments, “when you let the coin rest, the subject didn’t expect a reversal” after heads appeared.
You can apply the same thinking to your financial strategy, she said.
“Take time. Pause. Think over the merits of the case, evaluate the loan or investment.”
Most mutual funds come with a line like this: “Past performance is no indication of future success.”
Believe it, especially if you consider buying a fund with high fees and managers promising to beat results of the S&P 500, which can be attained with a low-fee index fund.
“People react to past returns, not forecasts,” Shue said. Every transaction has costs; gains can be “eaten up in a lot of fees.”
Academics largely favor low-cost index funds, she said.
Put aside your “overactive pattern recognition.”
“There is always going to be a fund that has done better by chance.”
Do you see behavior patterns of your own that may be ascribed to the Gambler’s Fallacy? Share with us in the comments below or on our Facebook page.