What Is Gambler’s Fallacy
Monte Carlo Fallacy or Gambler’s Fallacy is a false belief of a person who thinks that if a random event has happened continuously a certain number of times, there are chances it won’t be happening again in future. This is an erroneous thinking because the probability of a certain event occurring in future cannot be predicted based on the past events.
Gambler’s Fallacy in detail
Although Gambler’s Fallacy is an inaccurate representation of probability, it can be applied to Investing. After the trading sessions have shown a series of successive gains, the investors liquidate their investments in a belief that the position might decline.
Example to understand Gambler’s Fallacy
The best example to understand Gambler’s Fallacy would be through coin flip. Suppose you flip a coin nine times and every time it lands, it is with ‘heads’ face up. A believer of Gambler’s Fallacy would now predict that the next coin flip would have ‘tails’ face up. But this prediction could be wrong since the probability of the coin landing with ‘heads’ or ‘tails’ face up is same i.e.50%. So, one can understand here that every coin flipping event is independent and the next event cannot be determined based on the previous outcomes.
Suppose, a gambler is offered to predict the outcome of 11th coin flip before any coins have been flipped, the correct decision for him would be to reject the offer since there is very less chance of him giving a proper prediction. But, if the coins have been flipped ten times before and the outcomes have all been ‘heads’ face up, then there is a 50% chance that the 11th outcome would also be ‘heads’ up. This is the situation where it is safe to accept the offer and gamble.
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