Investing Assumptions Separate You From Your Hard-Earned Money

By TradeSmith Editorial Staff

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When I flip a coin, the odds of heads coming up are 50/50.

What are the odds of me flipping heads 10 times in a row? About 0.09%.

Now, say I flipped heads nine times in a row.

What are the odds I flip heads a 10th time?

They’re 50%.

Here’s why…

The first scenario looks at the odds of a series of 10 independent events occurring in a specific order. The belief that flip 10 will continue to be heads is what’s known as the gambler’s fallacy.

The second looks at one event independent of the last nine.

Independent events don’t care what happened in the past.

They only care about what’s happening right now.

And that’s an important lesson to keep in mind not only in a seesaw market like we have now, but also as we get closer to the end of the second quarter.

Independent Events versus Dependent Events

Naturally, we want to know which events are independent and which are dependent.

Earnings are a good case study.

We tend to think of earnings as dependent events, since the last quarter influences the current quarter.

In reality, the price action leading up to and after the earnings release is entirely independent.

However, it’s subject to broader trends.

Think of Apple Inc.’s (AAPL) earnings.

For years, the company always beat market expectations and shares typically popped afterward.

Right now, most stocks are getting hammered after their earnings announcements.

But just because Apple dropped the last two quarters in a row after earnings doesn’t mean it’s more or less likely to drop the following quarter.

Apple’s stock reacts not based on the past earnings but on the current results viewed in the broader market.

Meta Platforms Inc. (FB), the parent company of Facebook, is a great example of how present performance is not necessarily contingent on past results.

As I discussed recently, FB suffered an epic price drop of nearly 30% in early February following a dismal Q4 2021 earnings report. Meta had failed to meet earnings estimates and Facebook was losing daily active users for the first time ever, and the resulting pall cast over the company sent many investors skittering for safety.

Yet the following quarter, Q1 2022, Meta staged a comeback. The company was able to gain 40 million more daily active users and beat earnings estimates, causing the stock to rebound 18%.

A stock might get knocked down, but that doesn’t mean you can count on it staying down.

Avoiding the Gambler’s Fallacy

Most people confuse the gambler’s fallacy with the saying “the past predicts the future.”

The past certainly helps provide context, and historical data can be utilized to help make our decisions.

But it can’t be used to assume that just because a company had a bad Q1, it will follow with another bad quarter.

Making assumptions can be no better than guessing, or basically flipping a coin, and get you into trouble.

Imagine if you had tried to predict the trajectory of the Dow Jones Industrial Average based on its recent performance. The index recently had its longest losing streak since 1923 and shed 3,000 points over eight straight weeks. But then, last week, it gained 6.2%.

Just because the Dow dropped for eight weeks didn’t mean it was going to keep going lower.

As we get closer to the second half of the year and a new round of earnings reports, just remember that assuming anything can be a surefire way to lose your hard-earned money.