What is Gambler’s Fallacy? How it Impacts Decision Making while Trading?
By: Watsala Shakya
The gambler’s fallacy is falsely believing certain random events are far more likely to occur than other, while also being under the impression other events are not likely to occur based on the outcomes of previous events. While this way of thinking and believing is not based on facts, and is baseless, the Gambler’s fallacy occurs to us more times than we would be like to admit. The recurrent fallacy, which is also known as the Monte Carlo Fallacy, fails to consider each event as an independent with results that bear no repercussion to events in neither the future nor past. While this fallacy is more often associated with gambling which can be supported by the fact that it gets its name “ Monte Carlo Fallacy” as it occurred in the Monte Carlo Casino in Las Vegas sometime during 1913.
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Going Deeper into Gambler’s Fallacy
When a series of events that are random and independent from one another are analyzed based on facts and statistics, the outcome of the succeeding events can be predicted. This is not the case for the Gambler’s Fallacy. Random and independent series of events can be easily misinterpreted, which leaves the person with a prediction based on whims rather than facts and numbers. For instance, when tossing a coin, say for 7 times. Let’s say the 7 coin tosses resulted in all “heads”, a person may predict that the 8th coin toss would also be “heads”. If the person knows there is a 50/50 chance of the coin toss resulting on either heads or tails. Although the coin toss is not systematic, neither does it follow a mechanism, due to which believing the outcome could be either heads or tail would be subject to gambler’s fallacy.
The most famous case of gambler’s fallacy has been observed at the Monte Carlo casino at the roulette wheel, when the ball landed on black several times in a row. People speculated that the ball would soon land on red and hence began to place their bets based on this assumption. The ball had actually landed on red by the 27th time. Millions worth of chips had been lost by then. After realization of this phenomenon or way of thinking was made, the fallacy was named ‘Monte Carlo Fallacy’.
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Gambler’s Fallacy in Trading
Investors regularly commit gambler’s fallacy once they accept as true that a stock will lose or gain value after a series of buying and selling periods with the complete opposite movement. Some investors make the decision to liquidate their financial asset after it goes up after a series of trading sessions falsely believing that because the asset or stock has been resulting in gains, it is likely to go down soon during the following trading session.
A study by Stockl et al. (2015) on the evidence of gambler’s fallacy in an investment experiment based on behavioral biases believe that females were more prone to making decisions under the gambler’s fallacy than men.
Similarly, Assistant Professor, Rakesh H M observed the Bombay Stock Exchange for his 2013 research paper in which he found gambler’s fallacy in action. The study primarily focused on the stock and shares’ market price but also throws light on the way how trading these assets are affected by gambler’s fallacy. The study found that investors’ predictions affected by gambler’s fallacy when investing in stocks had adverse effects on the decision’s outcomes. It’s tried to prove that investors must make conscious decisions, as opposed to bias ones loosely based on assumptions. While this would help investors make rational decisions, it would also assist in correctly assessing the stock market collectively.
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