Hot land fallacy in financial markets

In 1978, Koppett revealed a system that he claimed could determine, by the end of January every year, whether the stock market would go up or down in that calendar year. His system had correctly predicted the market, he said, for the past eleven years. Of course, stock-picking systems are easy to identify in hindsight; the true test is whether they will work in the future. Koppett’s system passed that test too: judging the market by the Dow Jones Industrial Average, it worked for eleven straight years, from 1979 through 1989, got it wrong in 1990, and was correct again every year until 1998. 

But although Koppett’s predictions were correct for a streak of eighteen out of nineteen years, I feel confident in asserting that his streak involved no skill whatsoever. Why? Because Leonard Koppett was a columnist for Sporting News, and his system was based on the results of the Super Bowl, the championship game of professional football. Whenever the team from the (original) National Football League won, the stock market, he predicted, would rise. Whenever the team from the (original) American Football League won, he predicted, the market would go down. Given that information, few people would argue that Koppettwas anything but lucky. 

Yet had he had different credentials – and not revealed his method – he could have been hailed as the most clever analyst since Charles H. Dow.

Academics call the mistaken impression that a random streak is due to extraordinary performance the hot-land fallacy.

The lesson here is that bad players and teams have longer and more frequent streaks of failure than great players and great teams, and great players and great teams have longer and more frequent streaks of success than lesser players and lesser teams. But that is because their average failure or success rate is higher, and the higher the average rate, the longer and more frequent are the streaks that randomness will produce.

It is important in our own lives to take the long view and understand that streaks and other patterns that don’t appear random can indeed happen by pure chance. It is also important, when assessing others, to recognize that among a large group of people it would be very odd if one of them didn’t experience a long streak of successes or failures.

Nobel Prize – winning economist Merton Miller (no relation to Bill) wrote, “If there are 10,000 people looking at the stocks and trying to pick winners, one in 10,000 is going to score, by chance alone, and that’s all that’s going on. It’s a game, it’s a chance operation, and people think they are doing something purposeful but they’re really not.” 

We must all draw our own conclusions depending on the circumstances, but with an understanding of how randomness operates, at least our conclusions need not be naive.

Full Disclaimer: I am not a financial planner. The views expressed in this post are all mine and they may or may not suit your needs. Please do you own due diligence. I do not make money on any of the products suggested in this post. 


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