Clustering illusion refers to a cognitive bias in behavioral finance in which an investor observes patterns in what are actually random events. In other words, clustering illusion bias is the bias that arises from seeing a trend in random events that occur in clusters that are actually random events.
The clustering illusion bias is often called the “hot hand fallacy” and is often the source of gambling fallacies.
Understanding Clustering Illusion
Humans tend to see patterns in what are completely random outcomes. In other words, it is in our natural inclination to create order from chaos. Although it helps individuals make sense of randomness, the clustering illusion bias has drastically adverse implications for financial and investing decisions.
For example, if an investor took a sample of a four-day period where the stock markets went down, down, up, up, the investor might believe that a trend could be found when in fact there was not one.
Example of Clustering Illusion
Mutual Funds and the Clustering Illusion Bias
John is a student looking to invest the money he made over the summer into a mutual fund. From discussions with his finance friends, he often hears that the statement “a vast majority of mutual funds perform worse than the S&P 500.” Understanding the fact, he still decides to put his money into a mutual fund with an above-average performance recently in relation to the S&P 500 on the assumption that the fund manager will continue to generate above-average returns going forward.
In our example, John is exhibiting the clustering illusion bias by using the fund manager’s past performance and assuming that he will demonstrate a similarly good performance going forward. Therefore, John’s identified a “trend” that the manager will perform well going forward due to the latter’s past returns when, in fact, the performance of the mutual fund manager might be attributed to a number of factors such as market conditions or even luck.
Cluster Illusion and its Implications in Investing
The clustering illusion bias provides a number of detriments for investors as it can create traps. For example, the use of short-term performance returns may:
Convince an investor to invest in a particular asset class over another
Convince an investor to follow a specific investing style
Convince an investor to invest with a certain fund manager
In the context of investing, it is important to not place a great emphasis on short-term performance to identify trends, as doing so may be subject to cluster illusion bias. As is commonly said in the finance world: “Past performance is not indicative of future performance.”
The Monte Carlo Casino Example
It was reported that in 1913, during a game of roulette at the Monte Carlo Casino, the ball landed on black 26 times in a row. The chance of hitting a black ball in a game of roulette is 47.4%. Therefore, the probability of the ball landing on black 26 times in a row was roughly 1 in 67 million.
The Monte Carlo Casino event above is a perfect example of clustering illusion bias. For individuals who were present during that night, the thought process was that since the ball had landed on black so many times, it was bound to fall on red soon.
As we know, the outcome in a roulette game is an independent event – whether or not the ball hit black or red does not indicate what the ball will hit next. Gamblers lost a significant amount of money betting against black because they were sure that the black and red outcomes “had to even out.”
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