Betting on the stock market might be closer to gambling at the roulette table than you realize. Stop trying to predict the future and diversify your risk.    

My wife and I just got back from our favorite vacation spot – Las Vegas. I love everything about the place, but what really fascinates me is the behavior of gamblers. I liken their behavior to what many of you and your financial advisors do in your investment portfolios.

I’ve put together a few timeless lessons I’ve learned over my years of frequenting Sin City and how that relates to some costly investing mistakes. First stop: Roulette.

A common way to play roulette is to simply bet on either all the red numbers or all the black numbers. There’s an electronic record on the side of the wheel that shows what the last 10 or so numbers and colors have been (not unlike the ticker symbols flying on the bottom of the CNBC screen). Here’s one sequence of numbers that showed up when I was at the roulette table:
1 9 35 7 20 25 19 36 7 32

Looking at this sequence of numbers, half of the players bet on black with the next spin since it’s about time that black shows up right? The other half bet on red since the last five numbers were red and 80% of the previous ten numbers were red.

They’re trying to take advantage of an obvious streak. Looks like red’s where the easy money is, right? Obviously both sides can’t win on the next spin. There has to be a loser.

What’s the fallacy all of these gamblers are making? They’re seeing patterns that don’t exist. The ball has no memory. It doesn’t care whether the last number was red or black. It doesn’t care if the last hundred numbers it landed on were all black.

The next spin is independent of the spin before it. There’s no relationship between each spin of the ball. In other words with each spin, the chance of landing on black or red is the same. Yet people in Vegas extrapolate past combinations into the future.

This same gambler’s fallacy happens all the time with investors and a lot of financial advisors. You see “patterns” of investment returns that are just mirages.

For example, take a look at two investments, US stocks and US bonds this year. The following table shows which investment had the higher return from January-October of 2011. The investment on top had a higher return than the investment on the bottom:



Suppose it’s April 2011 and you’re at the investment roulette table. You’ve got to make a choice of betting on red (stocks) or black (bonds). What should you do? It seems like red is the sure winner, but for the next five months bonds far outperformed stocks.

Skip forward to September 2011. Now it looks like the sure winner is black, but just when you start betting on black, red shows up.

Just like the roulette tables in Vegas, you’ve made a classic investing mistake. The stock market does not know it’s previous history. It certainly doesn’t know when you’ve invested your hard earned money in it. And it’s past sequence of returns isn’t going to shed any light on what it’s going to do in the immediate future.

Burton Malkiel, an economics professor at Princeton, calls this the “random walk.” It means that the future direction of the stock market can’t be predicted from it’s past history. As he puts it, “a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts.”

Malkiel did a simple experiment years ago, and I modified it here to illustrate this concept. Suppose you start off with $50 and you start flipping coins. If you flip heads, you win $5. If you flip tails, you lose $5. I went to an online random coin flipper and flipped a coin 100 times. Then I looked at a sequence of past returns for the Dow Jones Industrial Average. Here’s what I found (see graphs below).


If I didn’t tell you ahead of time which chart represents my coin flips and which one represents the stock market, I bet half of you would guess incorrectly. The random coin flips look pretty similar to stock market trends. When you hear the financial experts talk about what you should do next with your portfolio, stop and think whether you’re just flipping coins.

Financial advisors also play investment roulette with your money all the time.

Here’s one example that happens at banks and brokerage firms. The advisor plugs you in to one of their managed model portfolios, perhaps consisting of about 40-50 exchange traded funds (these are like mutual funds that trade like stocks–more on this in a future column). You could have a China fund, an India fund, a clean energy fund, and S&P 500 fund, and so on. If you look carefully at your monthly statements, the funds switch around about every month or every few months. So an

Indonesia fund would replace the India fund, and a biotech fund would replace the clean energy fund, and so on. Unlike in Vegas this game doesn’t just have black and red–it’s got dozens of shades in between. It’s more like Russian roulette with your portfolio.

But as Malkiel states, financial advisors and “financial analysts in pin-striped suits do not like being compared to bare-assed apes.”

So do what a rational investor should do: Stop playing the investment roulette game altogether. Instead bet on black and red at the same time, and forget about which color’s going to show up next.

Setu Mazumdar, MD practices EM and he is the president of Lotus Wealth Solutions in Atlanta, GA www.lotuswealthsolutions.com



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