Gambler’s Fallacy and Investing

Let’s flip a coin.*

First flip: heads.  Second flip, also heads.  Then heads, heads, heads, heads and heads.

If  you’re most people, you’re probably thinking, “Tails are due!  There’s gotta be a tails on the next flip!”  Or you could be thinking: “I’m on a real heads streak – I bet the next flip is heads, too!” And that would be an excellent example of the gambler’s fallacy.

The gambler’s fallacy is the mistaken belief that previous trials influence independent future trials.  The key idea is independent.  The future trial cannot be influenced by previous trials.  For example:

  1. Odds of selecting one particular card from a well shuffled deck of cards, with the selected card replaced and reshuffled.  This is and example fo a series of independent trials.
  2. Odds of selecting one particular card from a well shuffled deck of cards, with the selected card removed from the deck.  As you remove cards, the odds of selecting the one particular card increase as the deck decreases.  These are not independent trials.

What does this have to do with investing?  Let’s imagine a slightly different scenario.

An investor purchases a stock.  The stock goes up.  Good for the investor!  The stock goes up.  And up.  And up.  Now the investor is starting to get nervous.  When will there be a correction?  After all, the stock can’t keep going up forever, right?  It’s due to go down.  And the investor sells the position, perhaps earlier than the investor would’ve had he or she not engaged in the gambler’s fallacy.

I’m sure you can come up with some good examples yourself.  Since our beliefs inform our actions, its worthwhile to make sure our beliefs are as correct as possible.  Beware the gamblers fallacy.

* Not a trick coin, a fair coin.

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