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Beware of Gambler’s Fallacy

Suppose you toss a coin nine times and for all the nine tosses you get a ‘heads’. Then, for the 10th toss it appears so natural that most people will predict a ‘tails’. This is called Gambler’s Fallacy.

It is wrong to assume that the 10th toss would "most probably" be a tails just because it was heads on nine consecutive previous occasions. Logically, it makes no difference what has happened in the past. Each toss is independent of the previous tosses. Therefore, for the 10th toss also the probability would be 50:50.

At casinos too people normally queue up to a particular slot machine where they see someone hitting a jackpot. This too is a fallacy because all slot machines are similarly programmed and totally random.

Bear in mind that many events are random in nature and as such do not have any previous memory. Therefore, in such instances, it would be erroneous to base your decisions on the past happenings. Luck…and only luck…will determine the next outcome.

As such if you carry forward this gambler’s fallacy to your investments too, it could prove disastrous.

Day trading in the markets too is a highly unpredictable and random event. There are just too many factors affecting the market — each pulling it in different directions — that it is impossible to arrive at a logical sum total effect of all these factors. In fact, it is not possible to even know all the events that will affect the market; how they will affect the market; when they will affect the market; and how much they will affect the market.

Yet people make predictions purely based on what happened yesterday, day-before-yesterday or last week. If a particular stock is either down (or up) consistently for a few days, doesn’t mean that it will now ‘most probably’ reverse its direction. There could be many reasons for a share to go up or down…but its price movement in the last few trading sessions is normally not amongst these valid reasons.

As such if you sell just because your stock was up for say 10 days consecutively, you may never make big money. Alternatively, if you buy just because a particular stock was down for say 10 days consecutively, you may lose big money.

Clearly, gambler’s fallacy is one risk to watch out for. Don’t look for patterns where none exist.

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