Let The Gambler's Fallacy and The Drawdown Impact Help Take Emotion Out of Investing

by Dr. Steve Sjuggerud

Let the Gambler's Fallacy and The Drawdown Impact Help Take Emotion Out of Investing

By Dr. Steve Sjuggerud, Investment U Advisory Panelist

Tuesday, December 06, 2002: Issue #195

The seminar I spoke at over the weekend was fabulous. Put on by the International Institute of Trading Mastery, it went from zero to 60 in seconds and covered every important to the elements of making money in stocks. Beginners and experts alike left learning a great deal. I'll be sure to let you know when we do it again.

For now, I wanted to pluck a gem of wisdom or two from what was taught and share it with you today. I've chosen "The Gambler's Fallacy" and "The Drawdown Impact." By understanding these two simple ideas - and remembering them in the heat of battle - you'll be able to stop making emotional investment decisions and go a long way toward improving your chances for investment success.

How Many Lost It All Even Though the Odds Were Stacked in Their Favor!

To illustrate the importance of these two concepts, IITM's Van Tharp had participants play a trading simulation game.

  • Van simulates 50 trades by pulling a marble out of a bag 50 times.
  • Each marble represents either a winning or losing investment.
  • You simply bet on whether he's going to pull out a winner or a loser before he pulls it out.

Sixty percent of the marbles are winners, so if everyone were to simply bet the same amount on every trade, they'd each come out a winner.

But everyone doesn't come out a winner.

Quite the contrary, when I've seen Tharp play the game, only a third of the people in the room are winners. Amazingly, out of the other two-thirds that lost money, half of them lost it all - in a game they were basically guaranteed to make a profit. This can easily happen when "gut feelings" guide your investment decisions.

Additionally, even though everyone began with the same amount of money, no two individuals in the room ended with the same amount of money (except those that went bankrupt). This all goes to show that the question, "How much to invest?" may be every bit as important as the more popular question, "What should I invest in?"

There were two special marbles in the bag to keep things interesting. One was a 10x winner - meaning if you bet $5,000 out of the initial (imaginary) $100,000 you were given to start with, you'd make 10 times your money on that bet, for a profit of $50,000. There was also a 5x loser in the hat. So if you bet $5,000 when Van pulled the 5x loser, you'd lose $25,000.

Ignore the Intuition, But Not The "Gambler's Fallacy"

So let's consider the Gambler's Fallacy. This one is simple. Yet nearly every blue-haired grandma with a plastic bucket in her hand falls for it. And most investors fall for it too.

Think of a coin toss. If a regular quarter came up heads nine times in a row, what is the chance it would come up heads on the next toss? Pretty slim, right? Think about it - what are the chances that a coin would land on heads 10 straight times? It's bound to be tails on the next toss, no?

Actually, the odds are 50/50 - exactly the same as the first coin toss. The coin has no memory of where it landed last time around. Each toss is unique.

This same idea - that each individual outcome is unique - applies to investors as well as players of Van Tharp's marble game "My last three bets were wrong, therefore chances are I'll be right on this one." This thinking is the Gambler's Fallacy. If you go with your initial feeling and ignore the Gambler's Fallacy in your investing or trading, chances are, you could end up broke, just like a handful of the players of Van's game.

After all, in Van's game you were practically guaranteed to win. But what are your guarantees in the stock market? There are none.

How Drawdowns Can Eliminate Emotional Investment Decisions

How did folks go broke in a game they were guaranteed to win? They didn't understand the impact of "drawdowns."

Let's say that, after a streak of losers, you had $50,000 left out of your original $100,000. And let's say you wanted to lay down a big bet to try and catch up with the rest of the crowd - say $10,000?

You may not realize it, but due to the rules of the game, you run the risk of getting wiped out. Let's say that Van pulls the one 5x loser marble out of the bag... poof, you're wiped out instantly. If you don't fully understand what you have at risk, you can (and eventually will) get clobbered.

As you know, I recommend limiting your downside risk to 25% on any given investment. This means that if the investment does fall that much, you "only" have to earn 33% to get back to where you started. I say "only" because if you're willing to have a 50% drawdown, you've got to earn 100% to get back to where you started. And if you have no limit, and one of your investments falls 90%, it has to rise 900% to get you back to where you started. That is the impact of drawdowns.

If you limit your drawdowns on your investments to 25% per investment (at Investment U we call this a Trailing Stop), you at least have a fighting chance of getting that money back. If you allow larger drawdowns, you're going to be a loser over the long run. No doubt about it.

So when you're in the heated, emotive game of investing, and you want to get back what's gone, remember the Gambler's Fallacy and the Drawdown Impact. Remembering these will save you from making a seriously bad decision. And by doing this, chances are your investments will outperform everyone you know.

Good investing,

Steve

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