Imagine flipping a coin five times in a row and getting five tails.
Guy A comes to you and says, “This coin has had five tails in a row. We are way past overdue a heads already. No coin can throw just tails all the time. All coins throw 50% heads and 50% tails and I don’t see why this one coin should be different. Remember the law of averages: over time, all things will go back to their average. So over a long enough period of time, you are certain to make money because we will get at least 5 more tails than heads to balance things out to a 1:1 ratio. Choose the safe option and bet on a heads for the next throw.”
Guy B comes to you and say, “This coin has had five tails in a row. Why should it stop right at the sixth throw? I mean, why should it stop all of a sudden? Why that number in particular? This is a clear tails market, this is impossible to deny. We are riding a trend and absolutely nothing at all shows that the sequence is about to end. It’s obvious to see that this one particular coin seems more likely to give a tails than a heads, so why would you bet on the least likely option? If anything, the five tails in a row show this coin is rigged in favor of tails, so bet on a tails for the next throw.”
The coin is tossed a sixth time…
… and the outcome is a tails.
Guy A: “Now heads is even more likely for the seventh throw. I mean, do people seriously expect a coin to always give tails? This would be silly: it would mean that you can print free money by always betting on tails. Yeah, it doesn’t work like that, of course: we are certainly not going to get only tails until the end of time. The likelihood of getting seven tails in a row is 1/128 – less than 1%! If you bet tails on the next coin flip, then you literally will have had the unluckiest streak in years. Imagine playing russian roulette seven times in a row, but with 3 bullets in the chamber instead of 1, and surviving all seven attempts! This is basically what just happened. Now is not the time to stop, and you should bet on heads again.”
Guy B: “We get another tails, exactly as I had predicted. Congratulations, you made quite a bit of money, and you are about to make more. There is no reason the coin should stop giving tails right now and I’m glad my experience and talent were of use. We are following a very strong trend; in fact, all my technical indicators show that this is a strong heads coin and that this is likely to continue. Rule number one of investing: you don’t stop when you win. Keep the winners, keep betting on tails and keep on making money!”
The coin is tossed a seventh time…
… and the outcome is a tails.
Guy A: “Sometimes, volatility likes to play tricks. We are entering a ridiculously volatile market: the Chinese have just entered the coin tossing market and this changed everything. Momentary disruption. I have never seen this happen before. Everything I just told you is still valid; in fact, it is even more likely now. Seven tails in a row. I think I’ve seen this once in my career. In fifty years, I’ve seen what you’ve just gone through happen exactly once – still, rest assured I made my money back within months. Really, you chose to enter the coin tossing market at the worst possible time. In all cases, there might still be some short term turbulence, but no coin can keep giving you just tails. It’s impossible. Heads-tossers have manipulated the market with falsified data from fake economical reports and created a bubble, but all bubbles burst, and usually violently, and fast. This is a clear tails bubble being formed right here; the coin tossing market is massively oversaturated with tails right now and one critical rule is, you don’t sell in a crash. Stick to the strategy and bet on heads again.”
Guy B: “Exactly as I predicted. Once might have been luck, but twice proves it: my models are working. Congratulations on your gain. At this point, we are hitting the full valuations with several of our twenty-nine mathematical models, with our variables going from one extreme to another. The new jobs report show we might be near a top, and our supercomputer, who can model 7 trillions possible scenario per second, indicate that the heads have arrived too fast, creating a sort of overvaluation. Technical indicators show the heads market might be peaking and it might be prudent to stop betting; while the trend has not been broken, a correction is possible. If you bet on heads, still the most likely scenario, bet a smaller amount.”
… but the outcome is a heads!
Guy A: “Here we go: the crash was long overdue. We just broke the 6-throws moving average, which, when coupled with a pattern star technical figure and a double-inverted Japanese candlestick, clearly show the beginning of a long-lasting heads market. We are about to be inundated with heads – in fact, the next resistance is pretty far away, at 3 heads. Remember that all coins will average 50% heads 50% tails over the long time, and so far we are at 6 tails to 1 heads ratio. Tails are still way overpriced. I think that if we break the resistance at 6 tails and 3 heads, we are heading lower, definitely to 6 tails and 6 heads and perhaps even 6 tails and 10 heads, the next support level. Of course, you will have understood that now is not the time to stop betting on heads. In all my career, I can’t think of a single time where the coin tossing market crashed by just 1 toss, so go heads again with heads.”
Guy B: “We have just hit a minor bump along the highway. There is no reason the coin tossing market should start to produce heads all of a sudden. In fact, absolutely none of the economic indicator seems to indicate that. This is just a normal market correction and it happens in almost any tails market. Yes, we are still in a tails market. I remember a time where we got 10 tails in a row, then 2 heads… and then 8 more tails! If I had exited after the 2 heads, can you believe how angry I would have been? In all cases, we had worst corrections in the past. In fact, a market with no correction at all would be suspicious. There is obviously some volatility factor due to a weakening Yen and losing one time happens: it could have happened one throw from now, two throws from now, etc. Better for it to happen now when you have less money invested, if you think about it. Now, I am even more certain of the validity my model because no model will ever be perfect. Since the trend is still tails, I am going to advise you to stick to your strategy and go tails again.”