How The Monte Carlo Fallacy Can Run Our Lives
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Do you know that many billions of dollars a year are thrown away because of a common logical fallacy? The fallacy is known as the Monte Carlo Fallacy or Gambler’s Fallacy, and it is such a pervasive cognitive error that a huge sector of industries has been built to profit from it. But do you know if it might be running your life in ways unrelated to casinos?

The simplest illustration of the Monte Carlo Fallacy is a series of coin tosses. If you toss a coin ten times, and each of the first nine tosses results in heads, do you assume the tenth toss is more or less likely to result in heads or tails?

Our human brains are wired to find a predictive pattern in the series of tosses. Some people may be inclined to assume that the tenth toss will continue the run of nine, and more likely to result in heads. But many other, perhaps most, people are inclined to believe that such a run is less and less probable with each toss, and they assume that the tenth toss is more likely to result in tails. Both groups of people are wrong. The correct answer is that the tenth toss is equally likely to produce either result, because each toss is an independent and random event.

In gambling, people who have suffered a string of losses often assume that their odds of winning the next round are increasing, which whets their appetite to continue gambling. This is the Monte Carlo Fallacy in action. Interestingly, if they win a couple of rounds in succession, they may feel it is the beginning of a winning streak, and that also whets their appetite to gamble. This is sometimes called the Hot Hand Fallacy, and it is close kin to the Monte Carlo Fallacy.

Did you notice how the only likely winner from either of these fallacies is the house?

Strictly speaking, the fallacies are only completely false when events are completely random. Life is often not completely random, but the human brain is wired to see more order in a sequence of events than is often the case in reality. We can become attached to seeing the world, others and even ourselves in patterns of outcomes that appear realistic but are not necessarily as predicative of the future as we imagine. This attachment to a sense of order can make living from day to day easier, but at the cost of obscuring important choices. Another cognitive error that can lurk here is confirmation bias, where you tend to interpret new information to confirm your preconceptions and avoid information and interpretations that disturb your preconceptions. You may not realize how often you bring these unexamined assumptions to bear on other aspects of your daily life, such as your career or your finances.

For example, let’s say you have been working hard to sell a product or service to different clients, and none have yet purchased it. If you start to see this as a pattern, you might be tempted to give up, by assuming that the pattern will necessarily continue. Or you may assume that nothing needs to change except a new prospect, because you’re due for a win after so many losses. Each client is different, so there is some randomness at play, which means that you should not lazily project the past into the future. Instead, you should focus on what is not random: the quality of your product or service, your search process for prospects, and your presentation. Changing any or all of those is more likely to change your results than relying on a past pattern. On the flip side, if you’ve had a run of easy sales, you can get trapped into expecting success and neglect the variable characteristics of future prospects. In each case, by applying a critical mindset that sorts the non-random from the random, you can create greater opportunity for your results to change for the better.

Every day is a new day, but we can become habituated to assuming that the new day will look remarkably like past days. If the assumption turns out to be true, it’s not necessarily because the past predicts the future. Instead, it could be because you’ve chosen to go on autopilot instead of making conscious choices that might change your future. This can lead to self-defeating passivity. Classic signs of this in the career context could include: failing to update your resume or answers to standard interview questions; letting your network and references go fallow; and opting entirely out of office politics instead of understanding that “politics” includes organizational relationships that may be vital to your success even outside your current organization.

What could change if people did not rely on these assumptions? What becomes more possible for them?

Investing is another area where cognitive errors commonly lead to costly, self-defeating errors. Many people have an investment style that might best be characterized as buy high and sell low, because they chase returns and assume that past performance really does indicate future results. There are others, probably fewer in number, who know that dips can represent buying opportunities, but not all of them do the hard work of sorting out the genuine opportunities from the clinkers, and so they invest with less discrimination than they should. Think of how many people who have put money that they need in the short term into investments that are designed for long-term investing. Likewise, think of the people who lock in their losses by yanking their long-term investments out of the market after a significant correction, and stick them in what amounts to a bank account, only to miss out on the initial and greatest part of a market recovery.

As we should all know by now, predicting the top or bottom of a market based solely on past patterns is a task at which many of the most highly rewarded people in our society can fail because they, too, underestimate the role of randomness. While there can be rewarding opportunities in randomness, they are random, so we should focus our energies on the non-random factors over which we can exercise a genuine choice, such as saving more money, defining our goals and risk profile, and building our knowledge.

How might people invest differently if they did not rely on these assumptions? What might happen if they sought objective feedback and guidance from a professional who’s not making those assumptions?

During the current financial panic, I’ve had a few chats with a commodity broker. One Friday, coincidentally after I had written this article, the broker exclaimed to me that he had been an idiot over that week. When I asked what he meant, he explained that he had done surprisingly well over the preceding two weeks by just guessing at possible market opportunities. But he began the following week thinking he had discerned the formula for his good fortune and “knew” just what to do next. What followed? He lost everything he had gained. “I did great for two weeks by just guessing; then, once I was sure I ‘knew’ what I was doing, I gave it all right back.” When I mentioned the cognitive errors I’ve discussed in this article, he remarked that he was a perfect example of them all.

Deeply ingrained habits of thought can discourage you from examining assumptions about how you think the world works. Fallacious assumptions can be a form of avoidance, and when avoidance runs your life, it can become self-defeating. Monte Carlo may glitter, but do you want to run your life as if it were a casino?

© 2008 Karl W. Saur. All rights reserved.