Avoid the Gambler's Fallacy in Trading

Imagine you flipped a coin two times in a row, and it showed heads both times. What do you think would come the third time?

A head again?

You never know, because you cannot predict future events based on past occurrences.

This is exactly what gambler’s fallacy is about!

What is the Gambler's Fallacy?

The gambler's fallacy is the wrong belief that the chances of something happening would change in the future because of what happened in the past.

It is a psychological bias that makes a trader think they should trust past events for their future trades, ignoring their trading plan and the fact that future market conditions can be different from those in the past.

Understanding Gambler’s Fallacy Through an Example

Let’s relate this term to gambling. This example is from a casino in 1913.

• The roulette wheel’s ball had fallen on black several times in a row.
• This led people to believe that it would fall on red soon, and they started placing their bets on red.
• The ball did fall on red, but only after a total of 26 turns.
• Accounts state that people lost millions of dollars by then.

What is the Main Reason for Gambler’s Fallacy?

We all have played games like skipping alternate tiles on roads, believing we’d lose if we stepped on them. This happens because of basic human tendency to look for patterns even in random outcomes.

For traders, it’s the same:

• Example: A trader might think, “The market has been down for the past two days, so it will go up tomorrow.”
• Reality: The market might go up the next day, but there is no pattern in it. It could just as easily go lower.

How to Avoid Gambler’s Fallacy?

1. Stick to Your Trading Plan:

   • Your trading plan is your best defense against biases like gambler’s fallacy.

2. Do Independent Research:

   • Avoid relying on past patterns. Instead, analyze the current market conditions.

3. Stay Updated:

   • Use facts, figures, and real-time market data to make informed decisions.

By staying disciplined and avoiding psychological traps, you can keep biases like gambler’s fallacy out of your trading decisions.