By Albert Phung
Key Concept No. 4: Gambler's Fallacy
When it comes to probability, a lack of understanding can lead to incorrect assumptions and predictions about the onset of events. One of these incorrect assumptions is called the gambler's fallacy.
In the gambler's fallacy, an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future.
For example, consider a series of 20 coin flips that have all landed with the "heads" side up. Under the gambler's fallacy, a person might predict that the next coin flip is more likely to land with the "tails" side up. This line of thinking represents an inaccurate understanding of probability because the likelihood of a fair coin turning up heads is always 50%. Each coin flip is an independent event, which means that any and all previous flips have no bearing on future flips.
Another common example of the gambler's fallacy can be found with people's relationship with slot machines. We've all heard about people who situate themselves at a single machine for hours at a time. Most of these people believe that every losing pull will bring them that much closer to the jackpot. What these gamblers don't realize is that due to the way the machines are programmed, the odds of winning a jackpot from a slot machine are equal with every pull (just like flipping a coin), so it doesn't matter if you play with a machine that just hit the jackpot or one that hasn't recently paid out.
Gambler's Fallacy In Investing
It's not hard to imagine that under certain circumstances, investors or traders can easily fall prey to the gambler's fallacy. For example, some investors believe that they should liquidate a position after it has gone up in a series of subsequent trading sessions because they don't believe that the position is likely to continue going up. Conversely, other investors might hold on to a stock that has fallen in multiple sessions because they view further declines as "improbable". Just because a stock has gone up on six consecutive trading sessions does not mean that it is less likely to go up on during the next session.
Avoiding Gambler's Fallacy
It's important to understand that in the case of independent events, the odds of any specific outcome happening on the next chance remains the same regardless of what preceded it. With the amount of noise inherent in the stock market, the same logic applies: Buying a stock because you believe that the prolonged trend is likely to reverse at any second is irrational. Investors should instead base their decisions on fundamental and/or technical analysis before determining what will happen to a trend.
Behavioral Finance: Key Concepts - Herd Behavior
InvestingInvesting, just like our day to day activities, is primarily driven by our behavioral patterns and general thought processes.
InvestingThey know more about stocks than the average person, but analysts are still affected by biases. Find out what they are.
InvestingIn recent years, the Chinese government's nationwide crackdown on corruption has sent gaming revenues in Macau into a tailspin that has only recently showed signs of ending. The island territory ...
InvestingMany people who have never invested before see it as just another form of gambling. Find out the truth.
InvestingJust because you're on a winning streak doesn't mean you're a skilled trader. Find out why.
InvestingIn the wake of the arrests by Chinese authorities of 18 employees of Crown Resorts for various "gambling crimes," analysts suggested that the blowback would be a problem for the Australian ...
InvestingWe break down the odds associated with casino games. Which game do you think offers the best chance at winning?
InsightsHedgeye Senior Macro analyst Darius Dale explains the fallacy of Wall Street’s S&P 500 year-end targets.
InvestingAre the markets random or cyclical? It depends on who you ask. Here, we go over both sides of the argument.