As the markets rally to make higher highs an irrational human emotion begins to impact risk taking decisions. People tend to stick to the idea that “what goes up must come down” (aka reversion to the mean).
We see this particular irrational behavior in casinos with the roulette wheel. Basically, when people see that red or black has come up several times in a row, then they think that the other color is “due.” Math tells us there is actually less than a 50% chance that Red or Black will come up on the next spin, but people weigh a greater probability on the color that has not appeared in a while as if some magical force in the universe demands equality for each color.
It would be like flipping a coin and if it comes up Heads 3 or 4 times in a row (i.e. a TREND) then a person is more likely to bet on tails on the next flip. Again, thinking that since the odds of Heads coming is 50% and the odds of Tails coming up is 50%, then it is only fair for Tails to get a chance becuase Heads just came up 4 times in a row.
This is completely IRRATIONAL risk taking behavior because the coin does not know it has landed on HEADS 4 times in a row. And the 50% thing, well that is based on infinite samples, not just the ones you are observing.
So in reality, Tails is no more or less likely to come up on the 5th flip.
How does this relate to trading/investment decisions?
In trending markets, traders tend to FIGHT trends, get stubborn and miss money making opportunities. So…even though the markets are rallying, most traders are not because of irrational thinking and waiting for the market to come back down. Well, Tails may land eventually, but no one knows when that is going to happen.
The big takeaway is to think objectively and not emotionally.
Dr Doug
