The Investor’s Fallacy

Good morning…

First off…Ellen and I are watching the documentary ‘Cheer’ on Netflix and it is great.

Second…I have NO idea what the S&P will do this year. I get the question all the time and I never try and guess and it really does not matter (unless it drops 50 percent like 2008) and there will be plenty of time to recognize that and get out.

That said… The last time the S&P 500 was lower during an election year with the President up for re-election was in 1940 (h/t Ryan Detrick)

Which brings me to this excellent post by Nick Magguilli titled ‘The Investor’s Fallacyand that the markets are never due for anything.

The gist (though you should read it all and check the charts and data):

Assume I flip a coin 5 times and get the following result (let H = heads and T = tails):


What is the probability that my sixth flip is also a heads (H)? Assuming the coin is fair (equal likelihood of heads and tails), you already know that the answer is 50%. Because coin flips are an independent process, prior flips have no bearing on future flips.

But it doesn’t feel that way does it? Even if you understand the basics of probability, after seeing five heads in a row, it can feel like a tails is “due” even though you know better. This feeling is known as the gambler’s fallacy and explains why it is hard for humans to understand random processes.

Investors have a similar problem when it comes to thinking about future market returns. I call it the investor’s fallacy. But what makes the investor’s fallacy more difficult than the gambler’s fallacy is that markets are not an independent process. What happened yesterday can affect what happens today. This explains why the very best days in the market and the very worst days tend to occur near each other. The same logic goes for what happened last week, last month, or last decade.

Because of this interdependence of market returns, it is easy for investors to convince themselves that markets can be due for good or bad years. And with the stellar performance in U.S. markets over the previous decade, it feels like a correction is warranted. However, if you examine the data you will realize that this thinking is just as flawed as the person expecting a tails after seeing five heads in a row. There is little to no relationship between prior 10-year returns and growth over the next 10 years.

Have a great day.

Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For full disclosures, click here.