How the “Gambler’s Fallacy” Distorts Your Investing Forecasts

Don’t assume future probabilities are altered by past events.

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Photo by Chris Liverani on Unsplash

In this article, we’ll cover the gambler’s fallacy, which investors commonly use to make questionable timing decisions about the stock market.

Author’s Note: This article is part of my series on investing psychology:

The Gambler’s Fallacy — What is it?

The gambler’s fallacy is the tendency of investors to think that future probabilities are somehow altered by past events, when in reality they are unchanged.

First, let’s look at a simple example to really understand the gambler’s fallacy.

Imagine we play a game where I pay you $1 every time you flip a (fair, non-rigged) coin and it lands on heads and you pay me $1 every time it lands on tails.

We start off and you flip the coin five times in a row, and all five times it lands on tails, meaning you pay me $5.

As you go to flip the coin the sixth time, you say out loud, “I can’t believe this has landed on tails five times in a row! What are the chances of that? It’s definitely overdue to land on heads.”

That sentiment is known as the “gambler’s fallacy.”

Each time you flip the coin, it has a 50–50 chance of landing on heads or tails. The fact that it happened to land on tails five times in a row has absolutely no influence on how it will land the sixth time.

Is it surprising that it hit tails five times in a row? Yes, absolutely!

But that has nothing to do with what will happen the sixth time.

How does the gambler’s fallacy apply to investing?

When it comes to stock market investing, the gambler’s fallacy tends to show up in a few different ways.

Sometimes investors think because the market has gone up for many days in a row, it’s now more likely to go down. Or they think that because a stock they hold has gone down by a lot, it’s now overdue to go back up.

Now, to be honest, there may be some truth to those perspectives. While flipping a coin is a strict 50–50 outcome each time, the stock market does have shifting probabilities.

The market doesn’t tend to go up forever. As buying gets exhausted and investors start to fear a bubble sell-offs become more likely.

And yes, it’s true, there’s evidence that stocks that have sold off sharply have a tendency to stage brief rebound rallies.

So while there’s some truth to these concepts, I still see investors oversimplify and base far too much of their forecast on expectations of a “long overdue” reversal of a recent trend.

Usually there are powerful forces that drive the direction of trends and investors would profit more often if they focused on understanding those underlying forces.

Interestingly, some investors make an opposite mistake by assuming recent trends will continue. I cover that in my article on “recency bias.”

What should you do instead?

Rather than assume something is bound to reverse simply because it’s been headed one way for a while, look at the underlying driver of the trend to better understand WHY it’s happening.

Ask yourself:

“What is the real driving force behind this trend? And how likely is it that this trend will continue or change?”

That should focus your attention on the true drivers of profit rather than flawed intuition that something is bound to happen soon simply because it hasn’t happened in a while.

Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. All information is obtained from sources believed to be reliable but cannot be guaranteed for accuracy or completeness. Use this information at your own risk.

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