While not as directly a result of a small sample size, the “if this happens, we are doomed” piece also does not rely on a lot of data in making its conjecture. It is an example of the “slippery slope” fallacy. Here, the suggestion is if we take a step on the slippery slope, we will inevitably slide toward some dire consequence.
The most common version says if some economic number comes in at some level or a particular event occurs, a recession or market drop will surely ensue. In recent years, this included tax code changes, election results, debt levels and trade wars.
Because economies and markets are far more complex than the narratives suggest and people adapt to changing circumstances, slippery slope narratives rarely pan out as described.
When it comes to extrapolating data into trends, I suspect chasing performance based on recent market moves may be the most common error. People buy after the market, or parts of it, rises and they wish to sell after a decline. It seems likely that many of the people trading crypto aren’t doing it because of a reasoned assessment of the future of crypto assets. They see prices soar and think its easy money because in their minds the probability of success is high.
While sample size is an issue, increasing the number of flips actually decreases the odds of meeting the 50/50 expectation. Flipping a coin twice has four possible outcomes, two of which are half heads and half tails. Flipping four times has 16 possible outcomes but only six of them involve 2 heads and 2 tails. Think of it this way: would you say the odds are high or low that after flipping a coin a million times, exactly 500,000 were heads and 500,000 were tails?
What does become more reliable is the range of results. The expected result is 50% heads. In a three-flip scenario, the range runs from 0% heads to 100% heads. After a million flips, you expect the resulting number of heads to be fairly close to 50% even if you don’t expect exactly 50%.
This is why when a player wins money at the craps table, the casino does not shut down the game. They know the more people play, the more the house will make over time even if they can’t be precisely certain how much they will make. Losing now and then, even losing big is an expectation of the casino, not a fear. The casino focusses on the long term and what they can control.
What if you flipped heads five times in a row? Would you say that was luck or skill? You would know it is luck because you did the flipping. When someone else does it though, you may be inclined to think they possess a special skill (or a rigged coin). This can be particularly true if the person said they would flip heads five times in a row before they started. Your perception of the event is influenced by the person’s declaration.
Differentiating between skill and luck is not always easy. Given the thousands upon thousands of investment managers in the marketplace, there are going to be quite a few that will appear skilled but are just lucky.
You are more likely to believe someone has skill if they tell you they have skill even if their results are random or manufactured, especially if you want to believe it. Probably the most pervasive bias we have encountered is confirmation bias. That’s a fancy term for the ancient wisdom, people hear what they want to hear.
In part, it is this psychology that enabled Bernie Madoff to pull off his scam. People wanted to believe Madoff’s exceptional results were the product of skill. When they saw a good number on their statements, instead of doubting, they were happy with him and with themselves for investing with him.
That’s conformation bias in action. You see it often. In a politically charged year, examples of the bias were everywhere in 2020.
Today’s media makes it challenging to stay focused on the long term and what really matters. By its nature, financial planning can help people reset and refocus on what is controllable and important to them. We can’t prevent every error, but we sure can help people try to act more like the casino and less like gamblers.
Dan Moisand, CFP, has been featured as one of America’s top independent financial planners by numerous magazines. He practices in Melbourne, Fla. You can reach him at [email protected].