Gambler's Fallacy - Explained
What is the Monte Carlo Fallacy?
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What is the Gambler's Fallacy?
The term gamblers fallacy is also commonly known as the Monte Carlo fallacy. It refers to a mistaken belief that since the occurrence of something is happening more frequent, its frequency is likely to diminish in the future or vice versa. In other words, gamblers fallacy is a logical belief that when constantly repeated, a process that happens more often will at some point become less frequent making it easy to predict the outcome of something. For instance, a gambler may falsely assume that since a certain football team has experience subsequent winnings in their matches, then, it is time for the team to start losing. In this case, the gambler has falsely assumed that since the team has been winning, it is likely to start losing in their future matches since it cant win all the time throughout. This is a false belief because the results of every match in this situation is independent. Meaning that the outcome of the next match has nothing to do with the results of the previous matches. Note that fallacy may come up in various situations. However, it happens more often in the world of gambling hence the term Gamblers fallacy.
How does the Gambler's Fallacy or Monte Carlo Fallacy Work?
In general, the gamblers fallacy is where one fails to understand the independence that exists between two events. This is because in most cases, people tend to rely on the results of past events to predict what will happen in the future. This, therefore, represents an erroneous understanding of probability. In investment, investors also experience gamblers fallacy which at times leads to them experiencing huge losses due to inaccurate prediction of stock market trends.
The History behind Gamblers Fallacy/Monte Carlo Fallacy
The origin of the term Monte Carlo fallacy can be traced back from an incident that occurred on August 18, 1913, in the Monte Carlo Casino. In this casino, during the spinning of the roulette wheel, the black color came up 29 times consecutively whenever the wheel was spanned. This incident in the Monte Carlo Casino happens to be iconic of the gamblers fallacy because gamblers counted huge losses during gambling in this particular place. This happened after the wheel brought up color black ten times in a row and then, the gamblers believed that there was no way color black will come up again. Using this reasoning, the majority of the gamblers then decided to place a large amount of money on color red believing it was its turn to come up. This logic was false as the back color continued to come up to 29 times in a raw. This made those who had placed their bet on the color red to lose all of their money. Note that the wheel has no capacity to memorize. Therefore, when it is span, the chances of red or black coming will always have the same chances. This is regardless of how many times each one of the colors has appeared in the previous spinning. So, gamblers lose when they mistakenly believe that the answer is YES forgetting that it can as well be NO.
Example of the Gambler's Fallacy
Generally, gamblers fallacy is common in the world of gambling but it can still be used in other situation including investment. Below are two examples of how gambling fallacy works.
Lets assume that investors believe that since the stock has been bringing in consistent positive returns, there will soon be a negative change on returns since there cannot be profits throughout. As a result, the investors then decide to liquidate their stocks to maximize their returns before the anticipated drop in returns happens. However, there is a possibility they may be in haste of selling their stock. This is because, instead of a stock experiencing low returns as they falsely thought, the returns may continue to rise further. This means that investors who decide to sell their stock due to the false belief of returns dropping will definitely miss out on future profits.
Consider a scenario where there is tossing of a coin and it happens to land with the head up 10 times in a raw. When you apply gamblers fallacy, an individual may now decide to put his or her bet on the tail in the next flip believing that there is no way the head will come up again. He or she forgets that the chances of a head or tail coming up in the next toss still remain 50%. Note that the gamblers fallacy, in this case, does not consider the results of every tossing event to be an independent event. This makes the person to strongly believe that since the head has come up many times, it is the tails turn to appear. Summary Gambling, in general, has its basis on a fallacy. This is because most gamblers tend to use the results of the previous events to forecast the outcomes of future events. For this reason, they always find themselves applying gamblers fallacy at some point. Nevertheless, when it comes to investing, it is important for you as an investor to understand how probability works, so that you do not fall a victim of gambling fallacy when doing an investment. This will save you from counting loses that may result from inaccurate investment decisions or choices.
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