The Most Authentic Guide on Personal Finance and Investments


(Funny) Words of Wisdom : "Someone stole all my credit cards, but I won't be reporting it. The thief spends less than my wife did." ~ Henny Youngman

Beware Of The Gambler’s Fallacy

Suppose, you toss a coin 9 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 known as Gambler’s Fallacy.

Just because it was 'heads' on nine consecutive previous occasions, it is wrong to assume that the 10th toss would "most probably" be a 'tails'.

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.

Hence, to think that 'tails' has a HIGH probability is an untrue and flawed assumption.

At casinos too, people normally queue up to a particular slot machine when they see someone hitting a jackpot on that machine. 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.

gamblers-fallacy

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

For example, 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 place their bets 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 definitely not among the valid reasons.

Hence, 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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