There are many examples of faulty reasoning when it comes to money, and gambling in particular. A particularly destructive notion is known as the "gambler's fallacy." Think of a gambler who has just lost 8 straight hands of blackjack. Played well, your odds of losing any given hand are closer to 52%, so that idea of losing 8 hands in a row seems improbable.
Reasonably, but incorrectly, the gambler will say to himself, "I must be due for a few winning hands here. I mean, what are the odds of losing 9 hands in a row?"
What he's really saying, is that the odds on the next hand are any different from any other hand. This is a triumph of emotional thinking over rational thinking, and it is a guaranteed way to lose a lot of money, fast. The cards don't care whether you've been winning or losing. The odds are always the same on every hand.
But there's another belief, popular among gamblers, which is that your luck changes depending on whether you're "hot" or "cold."Do you remember that scene from the Hangover where the guys aren't answering their phones? The father helpfully explains, "He's probably just on a heater. And you never walk away from the table when you're on a heater."
Of course, the idea of a "heater" is statistically misguided as well. But what's interesting is how that belief helps salvage bad behavior. It leads you to more moderate, measured decision making than the gambler's fallacy, which leads to increasingly reckless and destructive behavior. Both beliefs are untrue, but one is a lot better for you.
If you subscribe to the gambler's fallacy, you'll just keep going until you run out of money. The hot streak you're due for is under no obligation whatsoever to rescue you. But if you buy the idea that your luck can run hot or cold, after losing a few hands, you might decide to walk away and go do something else. That's a healthy behavior, and it stops the bleeding.
In effect, this hot/cold belief is the antidote to the gambler's fallacy. Whereas the gambler's fallacy means your unhappy emotional state leads to bad behavior, the "hot/cold" fallacy lets you cut your losses and leave. And in a casino, leaving is the only winning move.
It's helpful on the flipside too. Suppose you're on a hot streak and you've managed to win a decent bit of money vs the casino (against the odds). At some point, you'll lose once or twice in a row, and that "hot streak" you're feeling will come to an end. If you're observant when this happens, you will notice that your heater has ended. Why not end on a high note? It was fun while it lasted, but you're no longer hot. Preserve the memory and the positive experience, and just walk away.
Statistically, even after winning many hands, you're not any more or less likely to start losing than you were before. But the winning move is not to keep going until you've given back your winnings (which, statistically is what's going to happen). As always, the winning move is to walk away.
To summarize the scenarios I've laid out, there are a couple behaviors that are really destructive, and lead to you losing a lot of money, all while feeling like you're doing the right thing. Whether you're on a losing streak and think you're "due," or whether you're on a winning streak and want to keep going, you are going to give all your money to the casino.
These are the really bad outcomes where you're most likely to make bad decisions, bet too much, and lose money faster than you can afford.
But if you believe in the idea of being "hot" or "cold," you give yourself an emotional buffer against those worst impulses. You can tell yourself a story that helps you cut your losses (when you're on a cold streak), or walk away a winner (when your hot streak ends). Rather than losing money quickly, you manage to slow the bleeding, and "merely" lose money slowly.
The odds are against you either way, but you don't need to do the casino any favors when it comes to separating you from your money.
Now let's relate this to investing in publicly traded stocks, ETFs, and mutual funds.
In the investing world, unlike in a casino, the odds are actually in your favor. Whereas a casino will bankrupt you without breaking a sweat, the stock market can slowly make you rich.
Imagine a casino with a better than 50% chance of winning, where your winners pay out more than you put in. That's pretty normal for stocks depending on what timeframe you look at.
Now that's no guarantee you'll make money on every investment. Just like you can still win a few hands at the blackjack table, you can still lose money in stocks. Plenty of times, companies decline in value, and even go out of business.
Sears used to be a powerhouse, with a reputation similar to what Amazon has now. People couldn't imagine the world without this department store. Today, I don't think most people know where the closest Sears store would even be.
Success is about keeping your losers small, and letting your winners grow large. Even a 50-60% success rate can produce great results if the downside is managed appropriately.
There's an adage in the market that goes, "cut short your losers, and let your winners run." Sounds a lot like that "hot streak/cold streak" concept, doesn't it?
This idea works for similar reasons. People are usually too slow to take a loss on an investment, and sometimes will even double down on it. This is not a good practice. The investment keeps declining and declining, slooowly, stringing its investors along.
Meanwhile, the investors tell themselves, "if I can just get back to breakeven, I'll walk away happy." This is similar to the "gambler's fallacy" I referenced earlier.
Conversely, when it comes to business, I subscribe to David Gardner's proclamation that "winners keep winning." Winners are companies that have found a great product-market fit, that are growing rapidly to keep up with demand, and that have profitable business models. On top of which, that type of company finds it easier to get the best people from other companies to join their team. Eventually, it becomes an unstoppable force for wealth creation.
The best days at these companies usually lie years ahead in the future, when the companies will be worth many multiples of where they are today. Yet most people are tempted to sell them quickly and "lock in a profit."
So basically, the temptation is to let your losers get nice and big, while doing everything you can to keep your winners small and stunted. That's not a good way to get rich. So the advice to let your winners run, and cut your losses, is good advice. And unlike the "hot/cold streak" notion at casinos, this one is actually true!
Academic studies have validated the notion that stock market returns tend to come from a few big winners, which offset the large number of declining companies. It essentially comes down to the nature of exponential growth/shrinkage. I might do a more detailed writeup on these some other time.
But for now, here's an extreme example I put together in excel, where Stock A grows at 20% a year, and Stock B declines at 20% a year. What you'll see is that a portfolio owning both companies will actually go up over time.
My big takeaway for you is that even with in the categories of gambling vs investing, there are smarter ways of making decisions (and dumber ways, too). Now, gambling in a casino is, of course, not a good way to build wealth. Duh, right? But even then, there's a less stupid way to go about it.
Investing in the stock market actually is a good way to grow your wealth, though. And here too, there's a less stupid way to do it! Fascinating!
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