| Why Smart People Go Broke |
You’ve just thrown 20 heads in a row; what are the chances of the next toss being a head?
Of course, we all know the answer – at least, in our logical brain. The coin has no memory, no motive, and no awareness of what came before. The odds of the next toss being heads are still 50%.
But in the stock market, traders throw this reality out the window. Trading behaviour shows that under pressure, humans become deeply irrational.
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The Monte Carlo Fallacy
We start believing that after a long run in one direction, the market somehow “owes” us a move in the other.
- “The market has gone up too far – it has to crash.”
- “This stock has fallen for eight straight days – it must bounce.”
- “We’ve had too many green candles – a red one is due.”
This is called the Gambler’s Fallacy – the belief that after a streak of one outcome, the opposite outcome becomes more likely, even when the underlying probabilities have not changed.
It is also known as the Monte Carlo Fallacy after a famous incident at the Monte Carlo Casino in 1913, when gamblers watched a roulette wheel land on black 26 times in a row and began betting heavily on red, believing it had become “due.”
They lost millions. Why? Because the odds on the next spin had not changed.
Me too . .
And I am not immune from that either – I have been twitchy about the upward trajectory for some weeks – and have been proved wrong.
Thank goodness for the ITM strategy and the clear signals – otherwise I would have missed out on a lovely bull run.
When Traders Start Thinking Like Gamblers
In an article with the deeply enticing title of Idiosyncratic volatility shocks, behavior bias, and cross-sectional stock returns what the researchers found was surprisingly simple.
When a stock suddenly becomes much more volatile (its price starts swinging around wildly) – investors tend to misread what the volatility means.Instead of responding rationally to new information, many fall into psychological traps like the:
- disposition effect – holding losers too long and selling winners too early
- gambler’s fallacy – believing that after a big move in one direction, the opposite move is now “due”.
Earnings streaks & investor underreaction
A well-known market study found that investors systematically underreact to long streaks of positive earnings surprises. The researchers linked this to the gambler’s fallacy — investors subconsciously expect streaks to end.
So for example:
- company beats earnings 5 quarters in a row
- investors think “surely this quarter disappoints”
- the market underprices continued momentum
Mean Reversion
This is my pet hate: the idea that somehow prices have to ‘revert to the mean’.
Oh, really? If you had been waiting for the Dow to revert to its mean from a hundred years ago – well, good luck with that!
Yes, mean reversion is a genuine statistical concept. But many traders apply it to markets incorrectly. They assume that after a strong move prices are somehow “due” to snap back. They believe markets must “balance out” even when there is no statistical reason they should.
Markets are not random coin tosses. Over long periods they have shown a strong upward trend driven by earnings, productivity, population growth, inflation, and human progress itself.
Smart People Losing Money
Trader and researcher Ralph Vince ran a fascinating experiment.
Forty highly educated people – many with doctorates – were placed in a simulated trading environment. None had trading or statistics backgrounds.
Each participant started with $1,000 and was given:
- a system with a 60% win rate
- equal wins and losses (1:1 payoff)
- and 100 trades.
In other words, they were handed a game with the odds already stacked in their favour.
So what happened?
- Almost all of them lost money.
- Only two participants finished ahead after 100 trades.
Why?
Because after strings of losses, many increased their bet sizes believing a win was now “more likely.” Others became fearful after losses and reduced their position sizes just before winning streaks. In other words, they abandoned probability and started trading emotionally.
The odds never changed.
The system still had a 60% win rate.
But the participants behaved as though recent outcomes somehow altered future probabilities.
That is the gambler’s fallacy in action. And it explains why intelligent people can still lose money in markets despite having a profitable system.
The ITM Strategy Protects You
The market does not care that you think a reversal is “due”
That’s why it is important to have an objective system – and ITM is an objective strategy, not one that depends on our emotions.
Sure, we have emotions – we can’t stop them – but we can decide not to act on them.
ITM waits for evidence of reversal, not the feeling that reversal is “due.”
To the markets . . .
A rather nice week. More new highs. Yet again indicators have been proven wrong! Let’s check:
SPY Charts
SPY continues its upward trend – still no massive volumes but that doesn’t seem to bother it. I have left the MACD on the chart – showing the divergence – but guess what? Its prediction was wrong! Quelle surprise!
The histogram has started rising again – albeit quite slowly, but that is because the recent rise was so sharp and so the plateauing had a big effect on its downtrend.
As I say – probably ad nauseum- indicators work some of the time – we just don’t know when they are going to work.
On the log term chart SPY has breached the top of the trading channel. What does this mean? (Read over the blog before you give an answer!)
SPYG Charts
SPYG has definitely broken out of its consolidation period and headed upwards again.
And long term:
QQQ Charts
That is one very bouncy chart! $700? no problem! It is catching up rapidly on SPY.
Here are all three compared for the last 20 years (percentage increases):
QQQ makes SPY look positively sluggish!
(BTW – this was created here: https://heathercullen.com/stock-charts/. I notice when checking analytics that charts are not being used a lot – so it is just a suggestion. Hours of fun!)
On the long term chart QQQ also has pierced the top of the channel – as for SPY, check the blog above before deciding what it means!
VIX Chart (Volatility)
Still low volatility.
ITMeter
The week ahead.
Inflation data will dominate markets this week, with CPI and PPI likely to drive expectations around interest rates. Markets are still being pulled between AI optimism, geopolitical tensions, and concerns that inflation may remain stubbornly high.
Monday – May 11
• No major U.S. economic releases.
• Earnings: Fox Corp, Monday.com, Constellation Energy.
Tuesday – May 12
• CPI (Consumer Price Index).
• Earnings: JD.com, Robinhood, Under Armour.
• CPI will be closely watched for signs inflation is reaccelerating.
Wednesday – May 13
• PPI (Producer Price Index).
• Earnings: Alibaba, Cisco, Dynatrace.
• Cisco and Alibaba may provide further insight into AI infrastructure demand and global tech spending.
Thursday – May 14
• Retail Sales, Initial Jobless Claims.
• Earnings: Applied Materials, Figma, Nova Measuring.
• Applied Materials is a key read-through for semiconductor and AI capital expenditure.
Friday – May 15
• Industrial Production, Consumer Sentiment.
• Earnings season slows.
The three AI stocks reporting this week:
- Cisco – AI networking infrastructure demand.
- Applied Materials – AI semiconductor capex.
- Alibaba – can AI revive cloud growth?
Nvidia reports next week – but increasingly the AI race is no longer Nvidia alone. Google is now challenging Nvidia for AI leadership and is rapidly closing the gap in market capitalization.
The futures
Relatively flat – although I notice that the Russell is down a bit more. I think I really need to start checking that out, possibly offsetting the charts – ignore this – thinking to myself.
It’s May – why are you not in France?
If you have been following the blog for a while you would know that I usually spend my Australian winters travelling, and in May I am usually in France (the weather is great, everything is open, and there are no crowds). This year I’m giving it a miss as I am moving into my new place and want to sort that out. Here’s my new view:
2 Responses
Very timely!
Boy did I need to read this week’s blog and I’ll bet I wasn’t the only one.
Thank you heather
Kinda like the Elliott wave theory… since the stock market has made a great move up since someone invented a slice of bread it’s ready for the great slide down for a decade or more.
R