Gambler’s Fallacy?
The gambler’s or Monte Carlo fallacy arises when individuals incorrectly predict the likelihood of a random occurrence based on past outcomes.
This assumption is wrong, as previous occurrences do not affect the likelihood of future happenings.
Understanding Gambler’s Fallacy
The outcome of one or more random occurrences cannot influence or anticipate the following event.
Misjudging a succession of events as random and independent is the gambler’s fallacy. It entails incorrectly predicting that the next occurrence will reverse the previous ones.
Flip a Coin
Consider ten coin flips that all came up “heads.” A person may anticipate that the next coin flip will land “tails” up.
Suppose the person realizes this is a fair coin with a 50/50 probability of landing on either side and that coin flips are not statistically connected. In that case, they are falling prey to the gambler’s fallacy.
Every fair coin has a 50% chance of coming up heads. Previous coin flips do not affect future flips since each flip is independent.
A gambler should decline the offer to wager on 11 coin flips, resulting in 11 heads, due to the exceedingly low likelihood of this outcome.
Since the odds of the next flip being heads are still 50%, the gambler would have a 50% chance of winning if given the same wager after ten heads. The misconception is thinking that ten heads means an 11th is less likely.
To avoid the gambler’s fallacy, traders might follow their trading strategy with particular buy and sell signals based on independent research. They can record their pre- and post-trade behavior for study.
Gambler’s Fallacy examples
The gambler’s fallacy was most famously shown in Monaco’s Casino de Monte-Carlo in 1913. The roulette ball had hit black multiple times. It was believed that the ball would land on red shortly, so many bet it would spin on the following roulette wheel. The ball hit the red square after 26 rotations. Migrants had lost millions by then.
The gambler’s (Monte Carlo) fallacy applies to investment and misunderstands probability.
Investors may sell an investment after a prolonged period of favorable trading. They mistakenly assume the position will likely collapse after a streak of gains.
The Gambler’s Fallacy: How Far Back?
Over 200 years ago, French mathematician Pierre-Simon Laplace wrote about the behavior in his “Philosophical Essay on Probabilities.”
What Causes Gambler’s Fallacy?
Behaviorally, the gambler’s fallacy stems from tiny numbers—a misconception: tiny sample sets always represent more significant populations or results.
How to Avoid Gambler’s Fallacy
Stop believing that past events predict future events to avoid the gambler’s fallacy in trading and investing. To achieve this, traders and investors must employ independent research, stay current on facts, numbers, and techniques, track transactions and outcomes, and seek feedback.
Bottom Line
The gambler’s mistake is the incorrect notion that a random event will occur because several contrary events have occurred.
This is a misconception since random and independent occurrences cannot affect each other or the future.
Conclusion
- Gambler’s fallacy is the mistaken belief that a past chain of occurrences predicts a future event.
- 1913, the Casino de Monte-Carlo in Monaco witnessed the Monte Carlo mistake.
- The gambler’s mistake is wrong because each event is autonomous, and its consequences do not affect previous or present events.
- Investors and traders sometimes fall into the gambler’s trap, believing a stock will grow or lose value after several opposing sessions.
