This is the first of a series of blogs on 10 Logical fallacies: “Costly tricks our minds play on us”.
When it comes to probability, a lack of understanding can lead to incorrect assumptions and predictions about the onset of events. That is the basis for the Gambler’s fallacy.
One of the most famous disclaimers in finance is that “past performance is no guarantee of future results.” Even with that warning, it’s common to use what happened in the past to construct an idea of what will happen in the future.
How many of you have played roulette at a casino under the premise that a string of red increases the likelihood of a black outcome? The fact is, though, that a random event does not change the probability that certain events will occur in the future.
Flip a coin that lands on heads 20 times in a row, and you might predict it is “due” to land on tails. Probability tells us that it is still a 50/50 shot. If there were a disclaimer on coin flipping, it might say “past flips have no influence on future flips.”
Investors or traders can easily fall prey to the gambler’s fallacy. For example, some investors believe that they should liquidate a position after it has gone up in a series of subsequent trading sessions because they don’t believe that the position is likely to continue going up.
Conversely, other investors might hold on to a stock that has fallen in multiple sessions because they view further declines improbable. Just because a stock has gone up on six consecutive days does not mean that it is less likely to go up on the next trading session.
It’s crucial to understand that in the case of independent events, the odds of any specific outcome happening on the next chance remains the same regardless of what preceded it!”
I hope you are enjoying this summer and that you have some exciting things planned for this summer!
Next time we will look at logical fallacy number 2: Anchoring
See you soon,