One Fallacy Trumps Another?

You know I love this movie Sholay. If you are not yet aware of this then you really have been lazy and not been reading my dailies! Well, the point is that there are lots of things that I love about this movie. The slow unfolding of the story. The intermittent high voltage action which can hold its own even after 37 years of improvements in technology. The vast landscape. The classic cops vs bandits, the revenge drama and guy camaraderie mixed together into a heady cocktail. Nevertheless, in all this excellence, one thing never fails to baffle me. Why does Dharmendra never call Heads?

I mean he thinks that the coin is fair. The coin always comes up Heads in his experience. Why does he never call Head in at least one of the several times the coin is tossed in the film? Why does he keep agreeing to "Tail" unless he believes that after so many Heads this time it will definitely be "Tails"?

This same question was asked in a study conducted even among so called highly qualified finance professionals. They were asked to bet in multiples of one dollar on the toss of a fair coin. If they were right they would get the amount they bet. The way the game is structured, if it is played often enough then the player would end with the same amount he started out with. What the researchers were interested in seeing was the players reaction after a run of Heads or Tails was encountered.

The result was interesting. After say four Heads, players were willing to bet higher amounts on Tails and vice versa after a run of Tails. They were succumbing to the classic gamblers fallacy of assuming that what holds true for large numbers affects the individual try. That is to say that over a period of large number of attempts, a fair coin should throw up roughly 50% Heads. But that does not have to effect the result of the individual throw of the coin. After 4 heads the 5th throw can also land Heads with a 50% probability. The chances of a Tail does not increase.

This classic mistake is also seen in investing. While growth, returns or even prices of the entire class of stocks will show a mean reverting trend i.e periods of above average returns as a whole could see periods of below average returns as a whole, this principle cannot be used to create a mean reverting strategy for the individual stock. Just because a stock showed a large growth one month does not necessarily make it ripe for slower growth the next month. This strategy can only be used over the entire class in general i.e. for maybe a portfolio and not for a stock in particular. So using Mean Reversion for an individual stock or index could be a losing proposition.

I on the other hand, do not succumb to this gamblers fallacy. Never. I, if anything, succumb to the (probable) fallacy of believing in Trends. If I see a run of 3 Heads, then I might start assuming that there is a Trend somewhere and start betting more on Heads until a reverse trend of Tails is seen. If the coin is truly fair ( or in the case of my trading, if the market is truly random) then I should lose money using this strategy.

The fact that I have not might just mean one thing...No.. not that the market is not random and that it trends. I am under no illusions that my trading proves Trend following works. The fact that my trading has been profitable might just mean that I am lucky to have more people succumbing to the gamblers fallacy and betting on mean reversion than on Trends and until that remains the case, I might continue to make money believing in Trends.

I continue to be out of the market. I will go long above 5203 and sell short below 5030.