Behavioural Finance: Gambler’s Fallacy

Coin TossIf you and your friend has a bet on coin flips and for the 10th consecutive time (you are using a fair coin), you called out “heads”, but you lost, what would your thoughts be on the 11th toss?

“I have lost 10 times in a row. I am definitely going to win this time.”

Isn’t that what any normal human would think? But what does laws of probability and Math say? Each coin toss is an independent event and the probability is exactly 50-50. It doesn’t matter if it falls tails for 10 times or 100 times, the next toss can either turn out to be a head or a tail, in exactly 50% probability. But normal human mind doesn’t think about probability and math when he thinks “This time it I will definitely win”. It is the irrational mind that makes you think in such a way.

This is what is called Gambler’s Fallacy. This is more commonly seen in the slot machines, where people keep putting in coins after coins, thinking they are close to hitting the jackpot. When in reality the probability is the same on every coin they put. The machine is designed to payout in a particular ratio of winnings only and playing more doesn’t increase your chances of winning. Side Note: You will definitely lose more than you win in any slot machine.

Gambler’s Fallacy in Investing

This is widely seen in the field of investing/trading and many would have fallen in this trap. They would see a particular stock falling from Monday to Friday for 5 days straight. They would immediately think, the next trading day it will surely go back up and I can make a quick profit. Let me go buy now and sell on monday.

They fail to understand or analyse why the stock has been falling for 5 days – it could be numerous reasons like, policy decisions, competitors, losses, higher debt, corporate governance issue, etc. Without knowing the details of the stock movement, no one can predict when the stock will stop falling. It is foolish to think that the stock has nowhere to go but up. But numerous investors think like this and buy into worst possible companies and lose all their money.

How to avoid it?

First you need to understand that in any independent event, the odds of any specific event or outcome is the same regardless of how many times it has happened in the past. This is even more important in stock market because there is too much external noise and you wouldn’t even think clearly because of all the high volume trading.

Never buy a stock just because you “feel” that the trend has been downward for too long and will reverse any moment now. Always decide after doing sufficient fundamental or technical analysis before investing in stocks. Its better to wait till it goes upwards with a confirmation even if it means losing a few rupees than to hastily invest before it has reached a bottom.

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