Trading Lessons: We Don't Always Revert to the Mean
Even though the markets are rallying, most traders aren't
As the markets rally to make higher highs, an irrational human emotion begins to impact risk-taking decisions.
People tend to stick to the idea that "what goes up must come down" (also known as reversion to the mean).
We see this particular irrational behavior in casinos, around the roulette wheel.
Basically, when people see that red or black has come up several times in a row, they think that the other color is "due."
It would be like flipping a coin: If it came up heads 3 or 4 times in a row, (i.e. a "trend"), then a person is more likely to bet on tails on the next flip.
This is completely irrational risk-taking behavior, because the coin doesn't "know" that it's landed on heads 4 times in a row.
In fact, on the fifth flip, there's still a 50-50 chance of coming up either heads or tails.
How does this relate to trading and investment decisions?
In trending markets, traders tend to fight trends, get stubborn, and miss money-making opportunities.
So even though the markets are rallying, most traders aren't -- because of irrational thinking.
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