When it comes to probability, a lack of understanding can lead to incorrect assumptions and predictions about the onset of events.
One of these incorrect assumptions is called the Gambler’s Fallacy.
In the Gambler’s Fallacy, an individual erroneously believes that the onsets of certain random events are less likely to happen following an event or a series of events.
This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future.
For example, consider a series of 5 coin flips that have all landed with the “heads” side up.
Therefore, someone might predict that the next coin flip is more likely to land with the “tails” side up.
This line of thinking represents an inaccurate understanding of probability because the likelihood of a fair coin turning up heads is always 50%.
Each coin flip is an independent event, which means that any and all previous flips have no bearing on future flips.
It’s easy to think that under certain circumstances, investors can fall prey to the Gambler’s Fallacy.
For example, some investors believe that they should liquidate a position after it has gone up in a series of subsequent trading sessions because they don’t believe that the position is likely to continue going up.
On the other hand, other investors might hold on to a stock that has fallen in multiple sessions because they view further declines as “improbable”.
Just because a stock has gone up on 5 consecutive trading sessions does not mean that it is less likely to go up on during the next session.
In independent events, odds of any specific outcome happening on the next chance remain the same regardless of what preceded it.
In the stock markets the same logic applies:
Buying a stock because you believe that the prolonged trend is likely to reverse at any second is irrational.
Investors should instead base their decisions on fundamental and/or technical analysis before determining what will happen to a trend!