Gambler’s Fallacy – Betting on a trend reversal


Gambler’s Fallacy

The Gambler’s fallacy, also known as the Monte Carlo fallacy (because its most famous example happened in a Monte Carlo Casino in 1913), and also referred to as the fallacy of the maturity of chances, is the belief that if deviations from expected behaviour are observed in repeated independent trials of some random process, future deviations in the opposite direction are then more likely.

http://en.wikipedia.org/wiki/Gambler%27s_fallacy

When 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.

http://www.investopedia.com/terms/g/gamblersfallacy.asp

The Gambler’s Fallacy is committed when we start assuming that since a continuous series of events have happened, there should be a trend reversal. But, since the events are all independent, there is still a 50% chance that the same event could occur again.

A historical example – On August 18 1913 at the Monte Carlo casino in Monaco, the roulette wheel landed on black for more than a dozen straight times. The audience were amazed at it and started betting that the next roll would land on red, (just because they assumed that since it landed in black a dozen or more times, it is highly unlikely it will happen again), but, again and again it was landing on black. The roulette wheel landed 26 times in black before it fell in red. Needless to say, the gamblers lost heavily on their bets and the house enjoyed racking in money.

Gambler’s Fallacy in day to day lives:

  1. In stock markets how many times have we heard, ‘whatever goes up must come down’, and vice versa. This may be true eventually, but for how long and when will the trend reverse?
  2. In cricket, we have heard, he is long due for a ‘back to form’
  3. Investors see a pattern and begin to trade based on how they think that pattern will play out.
  4. If someone rolls dice and continuously gets a 1, we feel the next roll will not be 1 – though there is still a probability for a 1
  5. I have seen this stock falling for ‘n’ continuous trading day, and it cannot go beyond this – let me buy
  6. Some investors believe that they should sell their positions as there were a continuous rise on the price
  7. Buying lottery for a long time with no gains, assuming that since there were continuous losses, we are due for a win

Overcoming Gambler’s fallacy

  1. Always have an investment and asset allocation plan and follow it
  2. Remember that past continuous events are all independent and are not co-related and the probability of the same event is still possible
  3. Before making a decision, just think if you are following just a trend, or making a rational decision

My Experience

  1. During my early days investing in stocks, I have bought index ETFs just because they have fallen enough and there are chances of revival.
  2. I have also sold my positions after they have had a continuous run-up, just because I fear it is due for a fall.
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Filed under Behavioural Finance

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