Imagine a coin flipped 10 times coming up every time with “heads”. What would you bet for the 11th flip? Do you think it’s more likely to land on tails? If you’re tempted say yes, it may be a result of a gambler’s fallacy.
What is the gambler’s fallacy?
Gambler’s fallacy is a belief that the probability of something happening becomes higher or lower as the process is repeated.
It is the belief that random events are somehow interconnected and that each event influences the likelihood of another.
So one might interpret the outcomes of a future event by judging the corresponding events in the past, even if they are completely independent. This is a common mistake in human judgement.
In trading, this bias can cause traders to close profitable trades too early because they believe that the stock is unlikely to continue its trajectory and the chances of more profit become lower as time proceeds.
Traders falling victim to the gambler’s fallacy can take more risk when they lose. For example, they continue to increase the volume of their positions despite witnessing mounting losses – erroneously believing that price will more likely change direction with increasing losses. Often this is accompanied by an increase in the duration of losses.
Who was the first to describe the gambler’s fallacy?
The term “Gambler’s Fallacy” was first coined by famous researchers Amos Tversky and Daniel Kahneman in 1971. It is a representativeness heuristic, referring to an error in judgement.
The gambler’s fallacy, also referred to as the Monte Carlo fallacy, represents an inaccurate understanding of probability. One of the most vivid examples of this popular bias can be seen at the roulette wheel in a casino. Some gamblers believe that if the red numbers have come up more often in several previous rounds, they should place their next bets on black and vice versa. However, there is no rational support for this behaviour.
Gambler’s fallacy in trading and investing
We all know that it is insane to make trading decisions based on your “gut feeling”. However, in reality many traders make risky and unprofitable trading decisions, driven by such irrational beliefs.
The thing is, our brain is extremely good at making inferences. We pick up things, assemble them, join them together and create an inference. However, a probabilistic approach does not always work. To put it simply, our brain can find patterns that don't exist in real life.
A classic example of the gambler's fallacy in investing can be found when investors start to liquidate their positions over an asset that is continuously making new highs again and again. They are simply afraid that the longer the price goes up the sooner it will reverse – which is not always true.
A series of past events do not affect the probability of a particular event happening in the future. It’s the same with your trades: your past trades do not correspond to your future trades. Each trade is independent.
Instead of buying or selling a stock because you think that the prolonged trend is going to reverse at any single moment, you should base your trading decisions on thorough, fundamental and technical analysis. This will give you much more accurate information about what is going to happen with the asset’s trend.
The famous British economist and mathematician John Maynard Keynes once said: "The market can stay irrational longer than you can stay solvent."
How to avoid the gambler’s fallacy?
Looking back to the coin toss example: after you’ve thrown tails on a coin three times, if you believe that the probability of heads is less than 50 per cent, you risk making irrational decisions. When trading, pay close attention to price rises and falls, look at the overall trend – is it going up or down? Make your trading decisions based on logic, independent research and basic technical analysis.
