What is... | June 29, 2012

# What is the gambler’s fallacy?

Anyone who has flipped a coin to make a decision, such as which football team kicks off first, knows it's a simple 50:50 chance. There is a 50% chance it lands on "heads" and a 50% chance it lands on "tails". The result cannot be predicted because it is random.

But people might feel that if an ordinary coin has landed 20 times on heads in a row, the probability changes. Known as the “gambler’s fallacy”, we might think this history means there is a greater than 50% chance the next coin flip will land on tails. In reality, the probability remains 50:50.

The idea that a random pattern can change in future because of what has happened in the past is as relevant to investors as it is to football captains.

What are the chances?
The tendency to believe a winning streak must inevitably be followed by a series of losses is a form of thinking trap where people evaluate the probability of a future event by assessing how similar it is to what has happened before. In a famous example, gamblers at the Monte Carlo Casino in 1913 are said to have lost millions of francs by betting heavily that a streak of 15 consecutive black numbers on a roulette wheel would be followed by a run of reds. In fact, black came up again and again, leading to substantial losses for the players who kept betting on red.

This wish to see patterns that don’t exist persists today. It’s not only gamblers that fall for it. Research – titled Why do People Pay for Useless Advice? and published in 2012 – tested if students would pay for useless advice about future chance events, such as the outcome of coin tosses. They were.

Gambler’s fallacy applies when skill is involved as well. One 1985 study looked at the idea that some basketball players have “hot hands” and tested whether a player’s chance of making a scoring shot was related to whether they made the shot before. They found players thought they were more likely to get a shot if they got the one before – but their actual performance didn’t show this. The “hot hands” or lucky streak was only in the mind.

What goes up…
A danger for investors is to decide to buy or sell assets based on a mistaken belief that they can see a pattern that does not exist. The eZonomics article Where next for gold price?, written amid a surge in the price of the precious metal, makes the point that it is dangerous to extrapolate from short-term trends – and weighing all factors that drive gold price can be a better strategy than over relying on the immediate past performance.

Likewise, investors might liquidate a position that has gained in value over a series of consecutive trading sessions because they believe the next move must be down, basing the view on feeling rather than fact.

Don’t look back
This tendency can be compounded by the feeling that we “knew it all along” when we looking back at how investments behaved in the past. This hindsight bias means investors who made a series of successful bets may feel like they always knew they were onto a winner – even if their success was really only a matter of chance.

Investors can interpret a winning streak as a result of their judgement rather than luck and become dangerously overconfident.

Pick carefully
This tells us that investors need to beware of seeing patterns that do not exist and of confusing luck with skill. Part of the way to do this is the make long term saving and investment plans to meet financial goals.

Planning ahead rather than relying on quick gains helps avoid being tempted to make snap judgments. It might help us prevent falling for the gambler’s fallacy.

Phil Thornton

Lead consultant at Clariti Economics