Just to highlight how ridiculous people who are looking to make money act at times we only need to look at systems purporting to work on roulette tables. The explosion in recent years in the market for on-line casinos has had a concurrent explosion in a number of ‘get rich quick’ schemes relating to how you can win at roulette.
I have seen many examples of this and wish to concentrate on just one and how this relates to investors in general when considering investments.
There is, without doubt, a common denominator amongst roulette schemes and that is that patterns of results will average out over time.
The ball on the roulette wheel will produce a result at the conclusion of every spin. One is whether the number is red or black. In the event that someone banks their chips on one or other colour, they will either win or lose depending on whether that colour is produced by the spin of the ball. So for example if you put £10 on red and a red number comes up you will win £10. If a black number comes up you will lose £10. The whole matter is complicated by the number zero being on the wheel which produces a result where you lose 50% of your money of some other variation, depending on the exact rules of the game.
It is this zero that creates the margin for the casino. Let us ignore that for one moment and look back at the systems that are purported to work for punters.
Most “systems” suggest that a series of colours appearing one after another of the same colour will produce a backable system if you start backing against the other colour.
For example: - it is actually very unlikely that you will get six blacks in a row. The statistical basis for this is that assuming the odds of 1:2 of black appearing (which they are not the odds are 18:37 which is slightly less than 1:2). Then to get a series of two blacks in a row the odds are 1:4, for three in a row 1:8, four in a row 1:16, five in a row 1:32 and six blacks in a row 1:64. The people putting forward their winning systems suggest that if you do see a run of three blacks, for example, the chances of getting four blacks in a row are 1:16 and therefore you should start backing reds when you see a run of three blacks. This is a trick of the mind because most people think of that in logical terms as being correct, in other words red must come up sooner rather than later because the odds of having lots of black numbers in a row is highly unlikely. The odds of 40 blacks in a row are so astronomical it can’t even be written down.
But this is where some people don’t understand the true probability, because EVERY spin of the ball has exactly the same statistical probability of a black and red appearing. This is often described as a lack of memory in the ball itself and this is quite clearly correct.
People who study statistics know this is correct. The system “sellers” trick people by making them think of it in a different way and the logical simplistic brain that most people use when computing such positions get fooled by this and think that there is something in the system and that backing reds after a run of blacks increases their chances of making money. The systems purport to achieve this by suggesting you double your stakes each time a subsequent losing black appears in front of you by doubling up on red which sooner or later will win. However, even a probability of 1:1024 is still a probability and a probability of 1:1024 will occur on occasion, as will 1:2048 as will 1:4056. The problem with the system being put forward by the roulette specialists is that these unlikely scenarios will occur from time to time and unfortunately when they do they will wipe out any profits and more from the system.
When taking this on board, the roulette system fails. Of that there is no question. The statistics and maths tell us they will fail. Another example of this which is not necessarily exactly the same as the roulette example - but is very close - is when investors get fooled when things go up or down a lot believing that over time they must average out and therefore if a share price, for example, has steamed up to a very high number and increased magically over a year or two, it is likely to fall – in other words, what goes up must come down. The opposite is also true where people see something that has fallen heavily they think it must be due a rise in the future. This is often played out with markets so people think prices will adjust just because they have gone up for a long period of time or down for a long period of time.
Statistical analysis will tell you that the price in the future of a particular investment will have very little to do with it’s past history.
There is a factor here known as the ‘random walk’ which is very important in investing - which we will not touch on here - but anyone who understands a random walk, and what this means in terms of prices, will know that just because something has gone up or down a lot actually has very little bearing on what will happen in the future.
Indeed in some respects past price history can be remarkably deceiving, just as a run of blacks in a roulette wheel can be very deceiving because they don’t actually affect the probability of black or red appearing on the next spin and the same thing applies in the markets.
The historic price is very irrelevant to the future price.
Investors can be fooled in the same way as people who buy into roulette systems because they somehow believe what has happened in the past is hugely relevant to what will happen in the future.
I like to describe this as the history of prices fooling investors with respect to the future of prices. The historic price and what has happened in the past is almost entirely irrelevant.
What investors need to do, in my view, is continually take a fresh approach to any investment they hold. They need to look at the price today and how does that relate to the value of the investment. What is the value today and what is the prospect for that price increasing or decreasing in the future to meet that value?
I accept totally that these are incredibly difficult questions to answers but they are much better questions to ask and try and answer than simply looking at an investment and deciding the because it has done this or that in the past it will do this or that in the future.
Investors can get fooled in both directions. Some investors jump on a band wagon when they see a price increasing simply because they think that easy money is to be made – a typical example of this was the boom in technology shares in the UK, investors saw other people making easy money and jumped in regardless of the fundamentals.
The opposite is also true. Some people determine that something is going to go down simply because it has gone up in the past – what goes up must come down, what goes down must come up.
My point is that neither of these things is correct. Future prices are almost totally unique in their own right and have no bearing and are not influenced by past prices. Investors need to be very wary of this when choosing any investment structure or any particular investment to pursue.
