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Smart shortcuts: Is the market due for a downturn?

Sarah Newcomb, Ph.D  |  09 Oct 2019Text size  Decrease  Increase  |  
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A lot of investors are succumbing to a phenomenon known as the Gambler's Fallacy, as explained by Morningstar's behavioural economist Sarah Newcomb.

The US stock market has been growing for more than a decade. Is it due for a prolonged downturn? I won't speculate on that, but I will say that a lot of people seem to be falling prey to the Gambler's Fallacy when discussing the market today.

The Gambler's Fallacy is what we call that gut feeling that tells you it's just time for a trend to reverse, even when there is no fundamental evidence to support it. One clear way to illustrate the Gambler's Fallacy is using a roulette wheel.

Each time you spin the wheel, the ball has the same chance of landing on red as it does on black. The previous spin has no bearing on the one that comes after - and you know this. Still, in spite of that knowledge, if you were to spin the wheel 10 times and the first nine came up red, you'd probably feel like black was more likely to show up next just because it's "due."

It's a natural reaction to the knowledge that the odds are even, but that law of probability only applies to a very large number of spins, not strings of five, 10, or even 20. It is perfectly within the bounds of chance that the ball could land on red 100 times in a row, but that just feels wrong to us because we expect the colours to even out quickly.

Lottery players fall prey to the same error. For example, which of the following bets would you guess has the higher probability of winning in a pick-five draw with numbers 1 to 50?

Bet A: 2, 13, 25, 31, 43

Bet B: 4, 4, 4, 4, 4

You know it's a trick question. You know they have the same odds. The mathematical reasoning goes like this: The first draw is one of the numbers 1 to 50. Each time a number is drawn it is put back in, and the next draw can also be any one of the 50 numbers.

Therefore, any combination of the numbers has the same odds of winning as any other.
Still, to most people Bet A seems more likely because it feels more representative of a random draw. In fact, one study of the Maryland Lottery showed that once a number was drawn, players chose that number less frequently in the following weeks.

Predicting market behaviour

Right now, after an 11-year period of expansion in the US market, with the Dow at record highs, many economists and market pundits are predicting a downturn. It's not uncommon to hear phrases like, "The market is due for a correction," and that statement may be correct.

The important thing to ask, though is, "Why do you think that?" If the reason they give is that the market "usually" doesn't continue to rise for longer than a certain number of years, then the prediction is unfounded. Australia is in its 28th year without a recession, for example.

As Project Syndicate points out, "Expansions don't die of old age." Expansions end because of fundamental changes in economic conditions and in the underlying value of stocks and industries. "We've never seen a run this long," is not a real reason why a market would turn.

Maybe a downturn is due, but if you are going to put your money on that bet, make sure you have a better reason than, "It just feels like it's time."

Avoiding the booby trap

The gambler's fallacy is a tough one to tackle because it's powered by desire and fear (two very powerful emotions) disguised as logic. It is a classic shortcut of intuition, and it can be very hard to stop, check yourself, and really examine whether you're actually following sound logic, or just falling for emotional "mathiness."

To be frank, I think the best way to avoid the booby trap is to get out of the gambling mindset altogether. Research on investor behaviour shows that people who "tweak" their holdings to respond to new market information usually end up costing themselves in the long run.

The trading costs and fees associated with moving your money around – not to mention miscalculations and mispredictions – usually cost investors more than they gain by making a change. It's boring, but the buy-and-hold strategy really does mean that you shouldn't be thinking about moving your money around in the middle of the investment time period.

"But playing the market is fun," you say? "Besides, I'm better at it than you think." I know. It can be really fun, and there's a way to do it without losing your shirt.

If you love the thrill of trying to outsmart the herd and profit from short-term market shifts, then put aside a percentage of your money and use that to play the market. Just remember that short-term speculation is not the same as long-term investing.

There is nothing wrong with speculation, but please don't do it with your entire life's savings.

is a behavioural economist for Morningstar.

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