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Behavioral Finance: Key Concepts - Gambler's Fallacy

By Nathan Reiff

If you do not properly understand probability, you are more likely to make incorrect assumptions and predictions about certain types of events. The next bias that we’ll explore is called the gambler’s fallacy.

The gambler’s fallacy refers to the tendency of individuals to erroneously believe that the onset of a particular random event is more or less likely to happen following another event or a series of events. Logically, this line of thinking is incorrect; past events do not affect the probability that certain events will occur at a later time.

As an example, we might consider flipping a coin. If the coin has been flipped 20 times in a row and has landed with the “heads” side up each time, someone experiencing the gambler’s fallacy might predict that the next flip is more likely to land with the “tails” side up. After all, if it has landed with “heads” up so many times, it must be about time for the other outcome to occur, correct?

In fact, this is a completely inaccurate approach. The likelihood of a fair coin turning up heads or tails is always 50%. Because each coin flip is an independent event, all previous flips (no matter how unusual their outcomes) have no bearing on future flips.

Slot machines are another example of a gambler’s fallacy approach. The common picture of the “slot jockey” has someone sit in front of a slot machine for hours at a time. Some of these people believe that each losing pull is somehow bringing them closer to winning a big jackpot. However, what these gamblers don’t realize is that slot machines are designed to have the same odds of winning a jackpot for every single pull. For this reason, it makes no difference if you play with a machine that just hit the jackpot or on one that has not produced a win in a long time.

Gambler’s Fallacy in Investing

In many situations, investors can fall prey to the gambler’s fallacy as well. As an example, some investors hold that they should sell out of a position if it has gone up over several trading sessions. The thinking behind this is that the position is unlikely to continue to increase. On the other hand, some investors might hold on to a stock that has fallen for several consecutive session because it seems like it’s “time” for the stock to pick back up. There are other factors at play, and the situation is more complicated than the flip of a coin, but this line of thinking is a reflection of the gambler’s fallacy nonetheless. (For more, see Five Mental Mistakes That Affect Stock Analysts).

Avoiding the Gambler’s Fallacy

To avoid the gambler’s fallacy, investors should remember that the odds of any specific outcome happening on the next chance of an independent event is the same, regardless of what preceded it. This applies in the stock market as well as in the illustrative examples above: buying a stock because you believe the prolonged trend is likely to reverse at some point soon is an example of irrational behavior. Rather, investors should look to sound fundamental and/or technical analysis in order to predict what will happen with a trend.

Behavioral Finance: Key Concepts - Herd Behavior