What goes up must come down

I’ve picked heads on every coin toss for as long as I can remember. If you ask me why, I won’t have a reason. But I will have an opinion for you once I am on a cold streak. String five losses together and I’ll tell you emphatically that I’m due for a win on the next flip. I suspect most of us share this intuition despite any statistics courses we may have attended. In reality, the chances of stringing together five consecutive losses on a fair coin are 3.125%. Yet the chances of winning the next flip remain 50%.

When we were young, many of us learned, “what goes up must come down.” The idea became a nearly immutable fact of life—that coin can’t possibly land on tails again! Behavioral economists call this glitch in our reasoning “the gambler’s fallacy,” and it has caused a lot of investors a lot of pain. But if you can redirect your instincts, you can avoid sharing in the pain and maybe even profit from others’ fallacious gambles.

We’ve all seen a clickbait headline like, “[Insert hot stock] is down, buy now or miss the next rally.” Or, “[Insert hot stock] is up, sell before the bubble pops.” Each of these is playing on the gambler’s fallacy. But what just happened doesn’t affect the likelihood of what happens next. Just like a coin flip.

Perhaps the more important point is this: coin flips are beside the point for long-term investors anyways because stocks may trade like coin flips in the near-term but they follow fundamentals and value over the long-term.

Take Cisco, for example. The company was one of the most popular “picks and shovels” plays in the 1990s. The idea was that an investor need not waste time picking winners and losers of the internet era. Instead, just buy one of the few companies that made the hardware on which the internet ran and you couldn’t lose. Sound familiar?

Cisco’s market cap reached $556.7 billion after the turn of the century, gaining 6,100% from 1995 to its peak. To be sure, earnings rose a whopping ~393% over the same period. But they didn’t rise fast enough to keep Cisco’s valuation in reasonable territory.

The stock stopped going up in early 2000 (24 years from the day of this writing). Cisco’s market cap has since shrunk 64%, wiping out $354.7 billion, excluding dividends. Yet earnings are up 897% over the same period. So, what happened?

In the fervor to avoid missing out on one of the key internet plays, investors bid up Cisco’s stock to where the company’s actual earnings couldn’t feasibly meet expectations anytime soon. Recognizing the mismatch, thrifty stockholders headed for the door to take profits and Cisco spent 24 long years picking up the pieces investors had built into the sky in just five short ones.

If at some point during the run up, you asked whether the coin could keep landing on heads, you were asking the wrong question. If during the initial correction you asked whether the stock could keep hitting tails, you were asking the wrong question. The next flip is always 50/50 on a fair coin.

It's not a matter of heads or tails, anyways—stocks and their earnings are inextricably linked no matter how thin the tether between the two sometimes gets. And when that relationship breaks down, do expect a reversal of fortunes.

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