What is Gambler’s Fallacy
Gambler’s Fallacy is defined as a prediction of completely random occurrences based on what has happened in the past, or creating patterns where none exist.
It is a common misconception that if something occurs more frequently than usual during a given time, it will occur less frequently in the future, or that if something occurs less frequently than usual during a certain period, it will occur more frequently in the future.
The story behind the term “Gambler’s fallacy”
A remarkable event occurred on 18th August 1913, at the Monte Carlo Casino in Monaco. The action occurred at the roulette table. It was observed that the ball had dropped 8 to 9 times in a row on the black pockets.
Therefore, people began to gamble that the ball would land on the red pocket as the ball had fallen on the black pocket several times.
The ball continued to fall on the black pockets for the following several rounds. As the ball continued to land in the black pockets, the gamblers increased their bets on the red pockets, anticipating that the it would land on a red pocket sooner or later.
The ball did not fall on the red until the 27th spin of the roulette wheel. Thus, a great number of people lost a lot of money due to the long streak of betting on blacks.
Thus the term “gambler’s fallacy” was coined in when this event attracted people’s curiosity.
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Understanding Gambler’s Fallacy with an example
Consider you have flipped a coin a few times and gotten the same result, say heads. Just because you have got heads for the last consecutive times, can you assume that it will fall on tails this time? There is a hidden bias at work here.
We assume that the next throw will turn up to be tails because it has received heads for the last consecutive times. But the fact is that the probability of getting heads / tails on every coin flip will be 50%. This value is independent of the past results.
Thus, these similar principles are applicable in investing in stock market as well.
5 ways on how to Avoid Gambler’s Fallacy While Investing For Long Term
- Avoid investing based on technical indicator signals alone
- Avoiding herd mentality
- Understanding that past returns does not guarantee future returns
- Avoid treating yourself as an expert
- Reducing your ability to forecast
Let us understand these points in detail.
Here are 5 ways on how to Avoid Gambler’s Fallacy
Avoid Investing based on the technical indicator signals alone
Technical indicators are indicators that are present on the chart of a stock that are based on mathematical formulae. These indicators were created to aid in algo trading for large brokerage companies. Investors have this misconception that following technical indicators is a right way to invest in the stock market.
It is to be noted that just because these indicators have generated consistent returns in the past, it is not necessary that it will yield the similar returns in the future. Any technical indicator cannot be 100% efficient.
These indicators need to be only used as a reference for investing and only as one of the factors to influence the investment.
The true growth of the stock is completely dependent on the fundamental backbone of the company. A good fundamentals will provide the company with consistent profits which will reflect in the long term capital appreciation.
Avoiding herd mentality
Herd mentality form of investing is a scenario when an investor tends to follow the crowd while making investment bets. In this case an investor tried to participate in the stocks by following the crowd. This crowd is usually influenced by any influencer who has proven to correctly predict the stocks and have yielded extra ordinary returns.
This is a typical problem in the investment world. This bias arises from uncertainty and the perception that others may have more information, leading investors to mimic the investing decisions of others.
Such decisions may appear reasonable and even justified in the near term, but they frequently result in bubbles and busts.
Understanding that past returns does not guarantee future returns
If you have read the terms and conditions of any mutual fund, the first line states that “Mutual funds are subject to market risks, past performance may not guarantee future returns”.
This means that, if an investment has out performed in the past, it may not mean that it will yield similar returns in the future. Investors need to note this point and invest by looking at the true fundamentals of the company rather than looking at the attractive returns.
The returns on the investment depend on many internal and external factors. The internal factors include, company fundamentals, profits made in the particular year etc. The external factors include, the economy of the country, pandemic situation and the formation of a stable government. All these factors cumulatively affect the returns of the stock market.
Avoid treating yourself as an expert
An investor needs to make his investment decisions based on the facts and research. One must not consider themself as an expert in the stock market.
Just because an investor have generated decent returns in the past may not guarantee the same in the future. An investor should always have a learning attitude when it comes to investing.
Reduce your ability to forecast
Forecasting has been made popular by today’s media where research analyst just come and try to predict the stock price. Thus, a long term investor must not participate in this price game, and involve in taking a wider time frame approach to invest.
An investor should not try to time the market and predict the price of any stock. Predicting the price of the stock is the biggest pray to fall for gamblers fallacy.
People are sometimes confused about the difference between investing and gambling. Always keep in mind the basic concept of investment, which is investing only based on the fundamentals and backed with thorough research. Everything else is just guesswork.