What is gambler’s fallacy?

Gambler’s fallacy is a belief that the probability of something happening becomes lower as the process is repeated. In trading, this bias can cause traders to close a position prematurely because they believe that an instrument’s price is unlikely to continue its trend, and that the chances of it rising (or falling, in case of a short position) further decrease with time.

This cognitive bias, which is also known as Monte Carlo fallacy, may negatively affect decision-making, leading traders to take close winning positions early, or keep losing positions for too long.

Key takeaways

Gambler’s fallacy explained

Let’s assume a coin landed on “heads” every time it flipped five times. Will it fall on tails on the sixth occasion? If your answer is “yes” you may be a prey to the gambler’s fallacy bias.

The term “gambler’s fallacy” was first coined by famous researchers Amos Tversky and Daniel Kahneman – the fathers of behavioural economics – in 1971. It is a representativeness heuristic, referring to an error in judgement.

The gambler’s fallacy in trading represents an inaccurate understanding of probability. It’s based on the mistaken belief that if a certain outcome has not occurred for some time, it is more likely to happen soon.

A series of past events do not affect the probability of a particular event happening in the future. Likewise in trading: your past positions do not correspond to your future returns. Each trade outcome is independent. 

Gambler’s fallacy examples

• Selling off winning positions: A classic example of gambler’s fallacy in investing when traders start to close their positions on an asset that is continuously making new highs. They are simply afraid that the longer the price goes up the sooner it will reverse.

• Keeping losing positions: Traders affected by the gambler’s fallacy bias may continue to increase the volume of their positions despite witnessing mounting losses – erroneously believing that price will more likely change direction with increasing losses. 

Gambling fallacy vs Hot hand fallacy

Gambling fallacy is the binary opposite of the hot-hand fallacy, which is the belief that a successful streak is likely to continue. It comes from the saying that athletes have “hot hands” when they score repeatedly. In trading, this would lead traders to believe that if an asset’s price has been on an upward momentum, the bullish streak is likely to continue. 

How to avoid gambler’s fallacy

There are several tactics traders can use to identify the gambler’s fallacy and prevent it from affecting their trading decisions. 

• Independent research: Using independent research to inform your trading decisions can help in basing them on facts rather than emotions. 

• Trading strategy: Developing a trading plan and having clear entry and exit points in mind may deter you from impulsive trading.  

• Trading diary: Documenting your trading decisions and the rationale behind them can provide insight into recognising gambler’s fallacy, or any other cognitive bias.

• Feedback: Receiving feedback from other traders may be beneficial in opening up a different perspective on the thought process behind your decisions.

Conclusion 

Gambler’s fallacy is a cognitive bias that occurs when traders assume that the likelihood of a price trend continuing is reduced as time passes. This can lead to traders prematurely closing positions, as they wrongly believe that the trend is less likely to continue. 

This behavioural phenomena was first discovered by Amos Tversky and Daniel Kahneman in 1971. In trading, gambler’s fallacy may lead to traders closing a winning position too early, or keeping a losing position open for too long. Gambler’s fallacy is different from hot hand fallacy, which is the belief that a current trend is likely to continue. 

To avoid gambler’s fallacy traders can use independent research, design a trading strategy with clear entry and exit points, keep a record of their trading decisions in a diary, and seek feedback from other traders.