At this point, it's no secret that stock investors can sometimes fall prey to certain psychological distortions, fallacies, and biases. One pernicious thing about cognitive distortions, though, is that it can be quite difficult to recognize them while they're happening to you.
Today I'd like to contextualize what could be happening to you or people around you using some ideas related to gambling, and some acute history. It's my hope that in viewing biases through a specific prism, you may be able to evaluate your own thought processes and recognize if what patterns have looked like in the past.
Gambling Distortions
- The Gambler's Conceit - A fallacy in which the gambler believes they will be able to stop a risky behavior while still engaging in it, simply by exercising self-control and recognizing that it's time to quit while they're ahead at some future point in time.
- The Gambler's Ruin - A combination of ideas, including that a gambler with finite wealth will lose over time in a fair game against an opponent with infinite wealth, or that they will inevitably go broke (given enough time) if they are playing in a negative-expectation game.
- The Gambler's Fallacy - The (mistaken statistical) belief that something which has occurred more or less than expectation up until now will subsequently do the opposite in the future, by virtue of the original odds.
If you're not sure how the above applies to long-term investing, the answer is that it might not. But there are certain sorts of mistakes that can be made with investing strategy that bring each of these to the forefront.
The Temptation of Outperformance & The Gambler's Conceit
To me, the most interesting thing about the Gambler's Conceit is not that it's hard to exercise self-control or time the market; those ideas are pretty well-worn at this point. It's what happens to a person when they experience good luck and outperformance.
Specifically:
- A person may feel little incentive to quit or slow down when all of their results to-date have been positive.
- A person may start to attribute a winning streak to skill rather than luck and therefore think the only rational thing to do next is continue taking advantage of their edge.
Between 1995 and 1999, the U.S. stock market, particularly the technology sector, was on an unprecedented tear.
Here are some annual returns over that period:
S&P 500 Annual Total Returns: US Largest Company Stocks
- 1995: +37.58%
- 1996: +22.96%
- 1997: +33.36%
- 1998: +28.58%
- 1999: +21.04%
Nasdaq 100 Annual Total Returns: Generally, US Tech Stocks
- 1995: +42.54%
- 1996: +42.54%
- 1997: +20.63%
- 1998: +85.30%
- 1999: +101.95%
Yikes.
If you weren't involved at the time, then try to put yourself in the shoes of a hypothetical investor (or speculator) at that time. Is it at least possible that investors who concentrated in tech stocks felt vindicated by their “insightful” decisions, boasting returns far outpacing the broader market. Do you think a person would be inclined to stop, feeling that this was an incredible bit of luck that couldn't continue and that they'd extracted exactly the last bit of value out of this run? If so, did they stop at the end of 1998? Why not? And did they think that Mr. Market might be telling them that maybe we were on the verge of a total change in the world around us justifying ever higher market prices and multiples than we'd been used to before? And...is that what ultimately happened?
The Lessons of the "Lost Decade"
Well, because this is history, we know what happened next. The tech bubble burst, and the S&P 500 would go on to experience "The Lost Decade" returning -0.95% in total from December 31, 1999 to December 31, 2009. The Nasdaq did...not even as well as that. It had substantially negative returns throughout the same period - a period that would encompass 25% of a person's 40-year working life. Somehow even worse, a new investor to the Nasdaq in March 2000 would have had to wait 14 excruciating years to even break even and get back what they started with.
What could have been confused for skill in the late 1990s turned out to be luck amplified by a speculative mania. Investors who overconcentrated in US tech stocks, the former winners, faced devastating losses.
Fast forward to 2019, and while history doesn't repeat it does rhyme. The U.S. tech sector again became a shining star, with companies in cloud computing, artificial intelligence, and other digital solutions driving enormous gains. In both periods, investors might have mistaken luck for skill, confident in their ability to identify winners and outperform. This time, we don't have the benefit of hindsight to tell you how it unfolds for the next 10 years, and what "rhyming" may or may not wind up looking like.
But we can tell you: Overconfidence in a specific sector or strategy may lead to a perilous concentration, exposing investors to significant drawdowns when markets correct or leadership sectors shift.
The outcome is unknown, but the risk is the same. The point is that no one knows when to leave the table ahead of time, and few have the foresight to make the perfect decision at the exact right time.
Always remember to compare actual and expected returns to the idea of "cost of capital" - what will a stock or sector need to accomplish in terms of future cash flow and profitability to justify high multiples on earnings and to maintain annual rates of return well above historical averages? If they can maintain that kind of outperformance and produce, let's say, middle double digit type levels of growth year after year, then why will they continue to raise capital from equity markets and give away the excess return to equity investors, rather than borrowing at far more sober rates and keeping the difference? There aren't fixed answers here, but these are good questions to grapple with before participating and making assumptions.
A Negative Expectation Game - "The Gambler's Ruin", and a Clarification
"But wait" the most astute readers might be saying. "You just told us the S&P 500 experienced a lot of the pain. If we aren't supposed to buy and hold the whole market, then what are we supposed to do? Is the S&P 500 really the same as gambling?"
Excellent questions, hypothetical astute reader. One thing to note is that no blog post (especially not this one) is suited to tell you what you "should do" and this is not ever investment advice.
That said, the key to unlocking sound thinking in this situation is to understand that the problem grows and shrinks with scale.
- First of all, the most concentrated risk occurred for people who bought individual stocks. At least some of those go to zero, or decline and never recover (more on this below).
- People who thought they could outperform by choosing one "winning" sector also did comparatively poorly. Nasdaq is more concentrated, in this example, than S&P 500. It only works until it doesn't, and then it really doesn't.
- People who thought they were diversified with the S&P 500 and bought and held did ultimately, later, do OK by many measures. This isn't true if they had to get off the train (for personal reasons, retirement, etc) at any point during this period and didn't have the luxury of waiting it out, but still, on a long enough time horizon the S&P 500 has maintained its average returns over time.
- Here's the better point: the S&P 500 isn't "the whole market." It's just the biggest companies in the US. It's used as a common proxy for the market, but it isn't the market.
- There are other things to be invested in: foreign companies, smaller companies, private companies just to name a few.
- Investments don't have to be weighted by total size like the S&P 500, they could be weighted by other factors like relative value and profitability, as examples.
- Other indices (and factor-weightings) had very different results during "the Lost Decade" - small cap stocks, value stocks, and private equity indices all had healthy positive returns over the same stretch.
Research from DALBAR, a leading investment analytics firm, underscores the difficulty of outperforming the market. According to the 2023 results, the Average Equity Investor earned 5.5% less than the S&P 500. Their studies generally tend to reveal that the average equity investor consistently underperforms the broader market indices due to poor timing, overconcentration, behavioral biases, and high fees.
This is where the "Gambler's Ruin" comes in - trying to outperform the broad market using your finite individual resources with concentrated investing and securities selection is a negative expectation game - and the longer one plays a negative expectation game, the higher the probability of losing to the effectively infinite resources of the world markets.
Stock picking and market timing, for most investors, fall into this category. While a few may succeed over short periods, reversion to the mean tends to level the playing field over time. The broader market (with proper diversification, and a sophisticated, broad view of what "diversification" means) is a positive expectation game when held over the long term, as it tends to grow with economic progress. In contrast, stock picking and it's cousin sector-picking introduce unnecessary risks, akin to stepping into a casino and expecting to beat the house.
If you're wondering why it has to be a negative expectation game to try to beat the market, don't just look at the statistics (though those help) - remember the point about "cost of capital" above. Attempting to earn more from investments than is justified by the level of risk will always tend to be a losing game.
The Gambler's Fallacy: A Word About Single Stocks and Rebounds
These days, a lot has been said and digested about the perils of overconcentration in any one stock, so I won't spend too much time here detailing the risks. But it does still happen, for a few reasons. Sometimes a buy and hold stock from decades ago has grown to become a large percentage of a person's wealth, and sometimes a person's job pays them in (relatively large amounts of) the company's own stock.
And sometimes, when this does happen, I speak to people who think they have a good idea of where the stock price "should" be and what will happen even if it goes through a rough period.
Most are suprised to hear this:
Over the past 36 years, 42% of the stocks in the Russell 3000 went down by at least 50% and never recovered.*
Think about that. Stocks are not little microcosms of their indices. Unlike the history of broader indices, a decline in an individual stock is not necessarily (or historically) just a brief bout of expected volatility that's bound to recover and reach new heights. A significant percentage of the time, it just goes down and doesn't come back.
Remember the "Gambler's Fallacy" - the belief that because something hasn't gone as well as expected lately, that it's bound to turn around. Nothing like that is promised, expected, or guaranteed.
Walking Away from the Table
Note how pernicious the above fallacies can be in tandem: people experiencing risky win streaks assume they will be able to walk away at some point before they start to lose (but not during this win streak!), and people experiencing risky losing streaks believe their "luck" is inevitably going to return if they just ride it out.
Which of these people is walking away from the gamble?
Neither. When inappropriate risk is taken, any kind of performance can be viewed by the risk-taker as evidence to continue. Scary stuff.
The antidote to the Gambler’s Conceit in investing is adopting a disciplined, evidence-based strategy. An especially broad view of diversification and a long-term perspective (when your real time horizon is, in fact, long) can help mitigate the temptation to chase performance or overconcentrate in "hot" sectors.
Looking at the historical parallels of 1995–1999 and 2019 to present, investors should remind themselves that the broader market’s returns reflect the collective wisdom of all participants. Trying to outsmart it is not only a negative expectation game but one fraught with behavioral pitfalls that can derail financial goals. Further, the people taking the other side of your trades, as a collective, have resources far less exhaustible than your own.
Investors who resist the siren call of short-term outperformance and embrace the steady compounding of a well-diversified portfolio are better prepared to achieve lasting success. Knowing how to achieve diversification that generates positive risk-adjusted returns is where skill, knowledge, and access come into play.
The real skill isn’t in picking the winning stock; it’s in knowing when to step away from the gambler’s table and play a different game.
Diversification does not guarantee profit or protect against market loss.
--
* Source: Aperio, MSCI. Data from January 1987 through February 2023. Never recovered is defined as the stock remaining below the 50% impairment level in price.
Past performance is not a guarantee of future results. Indices are unmanaged and one cannot invest directly in an index. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit and inflation risk. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in securities of smaller companies tends to be more volatile and less liquid than securities of larger companies. Investing in foreign securities may involve heightened risk including currency fluctuations, less liquid trading markets, greater price volatility, political and economic instability, less publicly available information and changes in tax or currency laws. Such risks are enhanced in emerging markets.
Russell 3000 Index measures the performance of 3,000 publicly held US companies based on total market capitalization, which represents approximately 98% of the investable US equity market.
2024-7356795.1 Exp 11/26