International Journal of Business and Management Invention
ISSN (Online): 2319 – 8028, ISSN (Print): 2319 – 801X
www.ijbmi.org Volume 2 Issue 12ǁ December. 2013ǁ PP.01-07

Gambler’s Fallacy and Behavioral Finance In The
Financial Markets: A Case Study of Bombay Stock Exchange
Rakesh H M
Assistant Professor, Dept. of Business Administration

ABSTRACT : This research paper is relating to ‘behavioral finance’ and its theories which are in starkdisparity with that of conventional financial theories that have been experienced for decades. Since 1970s
behavioral finance has tried to explain and justify the existence of a number of market anomalies by
incorporating behavioral characteristics of financial decision making which appear significant to the trader/dealer. It highlights one aspect of behavioral finance that can be seen in the financial market Gambler’s
Fallacy. The study primarily focuses on the stock and shares’ market price but also throws light on the way how
trading of these devices/ gadgets/ instruments is affected by gambler’s fallacy. The sample population for thisresearch has been selected from Bombay Stock Exchange, India. The required data have been collected throughquestionnaire and the sample from people with no specialized financial knowledge. This research paper also
intends to bridge gap of knowledge by finding out the degree to which misleading notions of gambler which isalso called gambler’s fallacy exists and has a vital impact on the decisions of investors in India.

KEYWORDS: Behavioral finance, Stock market, Gambler’s Fallacy
I.

INTRODUCTION

Financial decisions are ideally assumed to be free of all emotional and psychological interference andall investors are assumed to be “wealth maximizers”. However,market trends paint a different picture; especiallyin a country like India, where stock market crashes are not unheard of and where markets are way too volatile ascompared to most of the international markets. On one hand it is true that investors have some level of financial
knowledge that they apply before making an investment decision and on the other hand the fact that they don‟t
always make rational decisions in their own interest cannot be overlooked.Behavioral Finance is described asthat field of finance that proposes psychology and human emotion-based theories to explain certain investment
anomalies that is seen in real life. It assumes the characteristics of market participants and their emotions
influence the investor‟s financial decisions and thus the market outcomes. Gambler‟s fallacy is referred to“Monte- Carlo fallacy or the Maturity of Chances fallacy” and is studied under behavioral finance. It is theconviction that if divergences/deviations from probable behavior are experiential in recurring independent testsof some unsystematic procedure then these divergences/deviations are likely to be evened out by contrary
deviations in the future. Gambler‟s Fallacy mainly revolves around the illogical concept of any investor that
believes that some event(X) is real inherently independent of any other event may be affected by the otherevent(Y)i.e. even though in reality; logically and rationally X does not affect the outcome or occurrence of Y.
Gambler‟s fallacy states that people illogical amuse that they do. Thisillogical approach often comes into play
because asimilarity between random processes is wrongly interpreted by an investor as a predictive relationshipbetween them.Gambler‟s Fallacy can be in any of the following forms; Run of good Luck, Law of Averages,
Law of Averages or Exhausted Its Luck, Run of Bad Luck. No matter what type of gambler‟s fallacy is taken
into account, all versions of gambler‟s fallacy are based on the same fundamental mistake of the failure tounderstand statistical independence.

II.

PURPOSE OF THE STUDYThis research attempts to focus on whether or not the gambler‟s fallacy overshadows Indian investor‟sfinancial decisions while they make them, or their financial decisions are completely separated from thebehavioral aspects due to their sound knowledge and understanding of the financial markets and the way they
work.

III.

HYPOTHESISHo: Gamblers fallacy doesn‟t affect investor‟s expectations while investing in stock market.
H1: Gamblers fallacy affects investor‟s expectations while investing in stock market.

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IV.

METHODOLOGY

The research aims to study the influence of investors‟ expectations by the behavioral attribute ofGambler‟s Fallacy. In order to determine the relationship between expectations and Gambler‟s Fallacy surveys
were conducted through questionnaires. The questions were phrased in such a way that the subject did not knowthat he/she is being tested for the Gambler‟s Fallacy to avoid bias in their answers. This is important if theinvestor is a victim of Gambler‟s Fallacy or not. Questions in the questionnaire are close ended questions andthe results are easy to comprehend and focus on the objective of the research. The sample is the investors of theStock Market of Bombay Stock Exchange only. The sample size is 60 investors who trade at BSE at different
points in time.

V.

SCOPE OF THE STUDY

India is a country with an unstable political environment that reflects to some level in the unstableeconomy and thus inevitably a relatively unstable stock market, however, the level of instability in the stock
markets surpasses by all standards the level of instability in the economy of the country. While the economy is
no doubt growing and flourishing with every passing year and generally different sectors of the economy seemto be doing well; the stock market is still unstable. This instability cannot be attributed alone to the economy asa whole or the political crisis; it is for these reasons decided to carry out a research in order to gain an insight
into the average non-specialized investor‟sdecision making process in India. In special, due to several
hindrances and limitations, scope of the study is confined to gambler‟s fallacy in Bombay Stock Exchange andtherefore, hypothesis is also tested on the sample of 60 investors taken from Bombay Stock Exchange.

VI.

LIMITATIONSThe study is limited to Bombay Stock Exchange only. Further studies can be carried out by consideringother Stock markets in the country. Another very important limitation is investors‟ hesitation because investors
were found very much reluctant to provide any sort of information.
Literature Review
William A. Branch and George W. Evans (2006) study suggest a model of bounded rationality to overcome
hindrance of Standard Rational Expectations (RE) to understand different prominent pragmatic regularities andobserves long-run excess returns. It explains alternative theoretical foundations for the empirical findings andtakes into account things beyond rational expectations and devises behavioral or through which these anomalies
might arise (e.g., Barberis, Shleifer, and Vishny (1998), Hong and Stein (1999), Hong, Stein, and Yu (2005),
and Lansing (2006). Previous models taking a behavioral perspective that give understanding of empirical
puzzles: overreaction, gambler‟s fallacy, undue probability changes, to „news‟ about dividends, excess trading,long-run predictability, and volatile long-run excess returns. Stock returns in many countries are positively
correlated in short term and negatively correlated over long run which is interpreted as evidence that there isinitially under reaction to news and later overreaction over time.
Jeff Dominitz Charles F. Manski (2005) focus on the more primary problem faced by economists working on
behavioral finance: the measuring and interpreting of expectations of equity returns. Measuring expectations is a
specifically challenging task since there are no formal models through which they can be measured. The paper
tests how behavioral aspects unintentionally influence the expectations of traders while they trade and thus
result in anomalies in the market as traders start trading based on those irrationally changed expectations.
Robert J Shiller (2002) focuses on the same lines, but on a broader perspective. He traces the market trends
from the efficient market theory to behavioral finance and the many traits identified in the field such asgambler‟s fallacy, over confidence and over reactions. He begins by tracing the historical background of theefficient markets theory which reached the height of its dominance in the 1970s but successive identification of
unexplainable anomalies in the market coupled with excessively volatile returns reaching all-time highs andlows for no apparently rational reason led financial analysts and economists to study more deeply into thedecision making process of investors who seem to be making decisions that don‟t always work for their own
benefit and defy simple investor logic in the 1980s.
Kent Daniel, David Hirshleifer, AvanidharSubrahmanyam (1998) analyzed the impact of following two
important psychological biases of investors on their investment decisions:(i) Investor overconfidence about the precision of private information Overconfidence implies negative longlag autocorrelations; excess volatility when managerial actions are correlated with stock miss-pricing,
public-event based return predictability.

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(ii) Biased self-attribution, which causes asymmetric shifts in investors‟ confidence as a function of theirinvestment outcomes.
While Canner, Mankiw and Weil (1997) try to explain the puzzle by relaxing the rigid assumptions of the
CAPM, the authors follow another idea: Learning from Benartzi and Thaler (2000) about investors‟ immature
diversification strategies, the paper find evidence that Asset Allocation Puzzle can be explained by a new
behavioral portfolio model. To verify the findings questionnaires were distributed among several investment
consultants who gave information about their market expectations. These expectations were heavily influenced
by the behavioral aspects such as gambler‟s fallacy and over confidence. The study also examines the losses thatare undertaken by the investors due to these behavioral aspects. Investors despite sound investment knowledge
tend to hold on to stocks that are going into loss simply because they‟ve held on to the stocks for a long time andthe stock had been performing well previously and the downward trend is observed only recently and vise versa
for investors who tend to get rid of stocks that seem to be doing well in the recent fast.
Jim Loy (1996) conducted one such study to explain at length the concept of gambler‟s fallacy. He presents thereaders with a number of options to choose from, for example, he presents average people with a simple
scenario; someone has just flipped 7 “heads” in a row. Then asks people what is the next flip likely to show? A)“Head” b) “Tail” c) “Head” and “Tail” are equally likely. From the answers collected he then explains why
people who had chosen option “A” and people who choose option “B” were both representing a form ofgambler‟s fallacy. The person who choose option “A” represented the form of gambler‟s fallacy where someone
assumes that since the coin showed “head” so many times before it will show heads again; in other words theprobability of a “head‟ in his/her head changed and he/she assumed the likelihood of a “head” increased justbecause the last 7 times showed “heads”. Similarly the person who chooses option “B” is also representing aform of gambler‟s fallacy; the form that alters the probability of something happening in a person‟s mind for norational reason. The person assumed that since the last 7 times showed a “head” the 8th flip would land on a“tail” simply because there had been too many times that “head” was shown. The right answer however, is
option “C” because no matter how many times the fair coin in flipped; the probability of a “head” or a “tail”
remains the same because all these events are independent in themselves from each other.
Clotfelter and Cook (1991, 1993) find evidence of the gambler‟s fallacy in analysis of data from the Marylandlottery‟s “Pick 3” numbers game.
Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, (1986) analyzed Corporate financial policy
implications along with many other untested implications come under the study of this theory. A study was
conducted of large pension funds over a decade by Brinson & Randolph to establish academic proof of theundeniable benefits of Asset Allocation which shows that approximately 94% variability of a fund‟s investment
return is caused by it as well as Stock selection and Market Timing accounted for only 4% and 2% of Portfolio
returns respectively. This study had significant impact on Wall Street and initially was to discredit the findings.
After all, the findings suggested that only 6% of a portfolio‟s returns could be attributed to skills that Wall Street
firms prided themselves on – Stock Selection and Timing. But here question arises doesn‟t their huge research
departments, and their related costs burdened on Investors, added any value/returns beyond what an Investor
could attain through passive Index Fund Investing? Therefore to establish Asset Allocation strategy, one musthas a better understanding of the returns/ risks of Assets classes historically. We can conclude better
understanding of potential futures returns of these classes by using the benefits of historical returns of different
asset classes.
Robert Merton (1973) showed how to generalize the capital asset pricing model (CAPM) to a comprehensive
inter-temporal general equilibrium model. While Robert Lucas (1978) published “Asset Prices in an Exchange
Economy”, which showed that in a rational expectations general equilibrium rational asset prices may have aforecast able element that is related to the forecast-ability of consumption. Douglas Breeden (1979) published
his theory of “consumption betas, where a stock‟s beta (which measures the sensitivity of 3 its return comparedto some index) was determined by the correlation of the stock‟s return with per capita consumption. These were
exciting theoretical advances at the time. Burton Malkiel (1973) wrote his 2 acclaimed book A Random Walk
Down Wall Street In 1973, which conveyed this excitement to a wider audience
Nicholas Barberis and Richard Thaler (1973) argue that some financial phenomena can plausibly beunderstood using models in which some agents are not fully rational. The field has two building blocks: limits toarbitrage, which argues that it can be difficult for rational traders to undo the dislocations caused by less rational
traders; and psychology, which catalogues the kinds of deviations from full rationality we might expect to see.

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The article discusses these two topics, and then present a number of behavioral finance applications: to theaggregate stock market, to the cross-section of average returns, to individual trading behavior, and to corporate
finance. The author closes by assessing progress in the field and speculating about its future course.
Analysis and Interpretation
The results show that Gambler‟s Fallacy exits in one form or another among investors in the Bombay
Stock Exchange. They make their investment decisions based on a wrongly assumed probability of a trend either
ending or continuing. A number of factors support this conclusion which is shown in the analysis of the results
herein. It was seen that investor in India make biased decisions because of the existence of gamblers fallacy.
The first control question was a general one. It gave the investors a hypothetical situation and was used todetermine the general psyche of the investors by testing whether or not they were in fact victim of gambler‟sfallacy. When provided with historical information (recent or otherwise) they were asked to predict what the
chances of a fair coin was to land on a “Head” or a “Tail”. This question was asked because fundamentally all
investors make certain assumptions and predications before investing in a stock i.e. they predict that the stock‟s
price will either remain the same or go up in which case they will either be avoiding potential losses or gaining
from the investment.

As can be seen 79 per cent of the investors gave an unbiased answer stating that a fair coin had a 50-50 percent
chance of landing on a “Head” or a “Tail”. This goes on to show that provided the investors are given no
historical trends or data (recent or otherwise) they will be rational in making predictions 79 times and theprobability of the event happening will remain what it actually is i.e. 50 percent.

The Normal Curve and Histogram shows the distribution of results clearly showing the mean to stand at 3.91
and the standard deviation at 0.35. Dismissing the possibility of the existence of gambler‟s fallacy in theinvestor‟s mind without any relevant past data availability.

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The next closed question was based on a situation related more closely to the investor‟s environment. It can beseen that almost 70% said that there is a 50-50 chances that the price may go up or may go down. This is when
they aren‟t given any additional information about the stock and so this proves that they are not biased in
making their decisions. And there are no chances of a probability of something happening in their minds if they
have no historical trend to mentally compare their decisions to.

The third question was designed to test for a form of Gamblers Fallacy which results when the investor wrongly
assuming that a „trend‟ exists because a series of random events happen in such a manner that they „seem‟ nonrandom and connected. This form of Gamblers Fallacy usually results when the mind identifies a pattern ofsome sort that it assumes is correct.

The above chart clearly shows that gambler‟s fallacy exists in the investors as 55 percent of them said that 73
percent chance of getting another “Tail” existed. While 27 per cent of them assumed that 16.50 percent chanceof there not being another “Tail” existed. This shows that while majority of the investors are victims of gamblers
fallacy that exists because investors assume that a random event will occur just because it has been occurring in
the past consistently, over 15 per cent are victims of the type of gamblers fallacy (referred to as “run of luck”)
which exists because investors assume that a certain event will NOT occur simply because it has been occurring“too many” times in the recent past. In both the cases the investors fail to see that the actual probability ofgetting a “Tail” or a “Head” remain the same.Another question designed is more relevant to the environmentthat investors work is presented investors with another hypothetical situation where they were asked to predict
what a particular stock‟s price would be given recent historical data trend. The question asked was: Suppose astocks price has been growing up by 5 points for the last 3 weeks (10, 15, and 20) what is the probability of theprices to increase by exactly 5 points the next week? 68 per cent of the investors predicted that just because thestock‟s price has been going up by 5 points each week it will continue to go up by 5 points the next week too.
As explained above this is a form of gambler‟s fallacy where investors mistake a random series of events as a
non-random pattern.

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Another question in the survey was designed to find out if the investors were a victim of gamblers fallacy
because of their tendency to pay more attention to what people and friends have to say or was it totallydependent on their individual perception of something happening.As can be seen below, 65 percent of theinvestors take friend‟s advice seriously while investing in the stocks, while only 11.5 per cent of the investors
actually take into account long term historical data as well as short term trends when investing into the stock
market. This can provide us with an insight into why the stock markets here locally are as volatile as they are.

To test the investor‟s confidence level, results show that investors were confident about the information thatthey had and so they based their decisions on that which resulted in biased decisions. Confidence level thus
contributed to gamblers fallacy in investors while they made their investing decisions.
Question
No.
1
2
3
4
5
6
7
8

Mean

Conclusion

3.81
4.13
3.09
4.61
1.9
3.58
4.71
1.35

Gamblers Fallacy exists
Gamblers Fallacy exists
Gamblers Fallacy exists
Gamblers Fallacy exists
Gamblers Fallacy exists
Gamblers Fallacy exists
Gamblers Fallacy exists
Gamblers Fallacy exists

VII.

CONCLUSION

Behavioral Finance is an area of study that still requires a lot of input. Whereas a number of studies
have been done in India, still has a long way to go before its investors can start looking into behavioral aspects
of investing. The aim of this paper is to get a better insight into the workings of the investors in the Bombay
Stock Market and to be able to determine to some extent why the local stock markets here are as volatile andunpredictable as they are. There are several types of gamblers fallacy that are seen in the investors‟ stock
exchange. This attribute of behavior has forced investors to make biased decisions. Therefore the hypothesis i.e.
investors‟ expectations are affected by gamblers fallacy while investing in stocks is proven which adversely
affect the outcome of the investing decisions.Investor needs to make a conscious effort to make sure that theirinvesting decisions are not bias and that they make rational decisions based on calculated facts and not loose
assumptions. Only then can the stock market be more stable collectively.

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