Gambler's fallacy is a behavioral trait which we should be aware of. This is because this can affect our performance when it comes to investing. As defined by Investopedia, gambler's fallacy is when an individual erroneously believes that the onset of a certain random event is less likely or rather, more likely to happen following an event or a series of events.Personally, I had a brush with this fallacy a few months ago and that cost me quite dearly in my point of entries for some of the stocks that I had bought. Back in October last year, I was waiting by the sidelines to pick up some counters at a bargain. In the days before the STI found its interim bottom on the 28th of October last year at the low of 1473, the closing of STI was mainly negative, In fact, 7 out of the last 9 trading days before that interim market low were negative. The last day before that interim bottom was the worst as STI tanked by a percentage of around 7.1%. During this entire period, I was rather pleased that the market was plunging as it made the purchase of stocks cheaper but somehow at the same time, there was some fear creeping at the back of my mind due to the relentless plunging of the markets.
On the 28th of October, STI opened with a huge gap down at around 1496 and touched a low of 1473. Without any reason, STI went on to rally to close at a level of 1666 and that was a huge percentage gain of 13.1% on a significant trading volume. From the point of technical analysis, I knew that the probablity that the market has bottomed is pretty high thus I decided to make my purchase of stocks the next day.
When the market opened the next day, I did not purchase the stocks which I had in mind. Why ? This was because I had let fear overwhelmed me irrationally. Somehow, I felt since the market has been plunging most of the time before the huge rally on the 28th of October, it would continue to plunge more and that was completely illogical. After all, the plunging of the STI for the past few days does not implies that the STI will continue to plunge indefinitely. If my reasoning was logical, STI will hit ground zero within two weeks but that would be impossible.
In the end, I made my purchase of stocks a few days after the interim bottom was formed but by then, STI is already somewhere off the bottom already.
To overcome this, it would be important to separate your logical reasoning from any reasoning that is influenced by emotions or any irrational form of reasoning. Once this is done, a plan will have to be made based on this logical reasoning only after which, this plan will then be resolved or be carried out.
On hindsight, I should have took some time off to think about it back then. After separating the fear that was clouding my logical reasoning, I would make a plan that will be carried out the following day. For example, this plan would have been something like "Buy 10 lots of stock X and 50 lots of stock Y at 10am the next day". When the next day arrived, I would just follow through to execute this plan regardless of my emotions.
I do think that this fallacy is one of the main reasons why the majority of investors tend to buy high and sell low instead of buying low and selling high and I will be discussing on this in a subsequent post.
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On the other hand, will you feel vindicated if indeed the STI plunged further? Hindsight is always 6/6.
ReplyDeleteI recommend reading a book called Fooled by Randomness by Taleb Nassim. It gives great insight on this topic.
Hi bbqchickenwings,
ReplyDeleteWhether the STI will plunge further is not really the issue for my post. It's more of whether the way I think and execute my actions are based on sound reasoning or are they clouded by other factors such as my emotions. I guess that this post of mine is leaning towards behavioral finance. Participants in the market are not as efficient as one may thinks and they are often driven by emotions and irrational reasoning.
I heard great things about that book and I will definitely pick that book up in the near future. Thanks for the recommendation.
Kay