The Greatest Gambler's Fallacy
What is the 'Gambler's Fallacy'
The gambler's fallacy is when an individual erroneously believes that the onset of a certain random event is 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 20 coin flips that have all landed with the "heads" side up. Under the gambler's fallacy, a person 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.
This can be extended to investing as some investors believe that they should liquidate a position after it has gone up in a series of the subsequent trading session because they don't believe that the position is likely to continue going up.
The famous gambler's fallacy, also known as the Monte Carlo fallacy
The most famous example of the gambler’s fallacy occurred in a game of roulette at the Monte Carlo Casino on August 18, 1913, when the ball fell in black 26 times in a row. This was an extremely uncommon occurrence, although no more or less common than any of the other 67,108,863 sequences of 26 red or black. Gamblers lost millions of francs betting against black, reasoning incorrectly that the streak was causing an "imbalance" in the randomness of the wheel, and that it had to be followed by a long streak of red.
Hot-hand Fallacy: A reversal of Gambler’s Fallacy
According to Wikipedia, the "hot-hand fallacy" (also known as the "hot hand phenomenon" or "hot hand") is described as the fallacious belief that a person who has experienced success with a random event has a greater chance of further success in additional attempts. The concept has been applied primarily to sports, such as basketball.
While previous success at a skill-based athletic task, such as making a shot in basketball can change the psychological behaviour and subsequent success rate of a player, researchers for many years did not find evidence for a "hot hand" in practice.
However, later research has questioned whether the belief is indeed a fallacy. More recent studies using modern statistical analysis have shown that there is evidence for the "hot hand" and that in fact, it may not be a fallacy.
1985 "Hot Hand in Basketball" paper
The fallacy was first described in a 1985 paper by Amos Tversky, Thomas Gilovich, and Robert Vallone. The "Hot Hand in Basketball" study questioned the theory that basketball players have "hot hands", that is, that they are more likely to make a successful shot if their previous shot was
The study looked at the inability of respondents to properly understand randomness and random events; much like innumeracy can impair a person's judgement of statistical information, the hot hand fallacy can lead people to form incorrect assumptions regarding random events. The three researchers provide an example in the study regarding the "coin toss"; respondents expected even short sequences of heads and tails to be approximately 50% heads and 50% tails.
The study proposed two biases that are created by the kind of thought pattern applied to the coin toss: it could lead an individual to believe that the probability of heads or tails increases after a long sequence of either has occurred (known as the gambler's fallacy); or it could cause an individual to reject randomness due to a belief that a streak of either outcome is not representative of a random sample.
The difference …
A study was conducted to examine the difference between the hot-hand and gambler's fallacy. The gambler's fallacy is the expectation of a reversal following a run of one outcome. Gambler's fallacy occurs mostly in cases in which people feel that an event is random, such as rolling a pair of dice on a craps table or spinning the roulette wheel.
It is caused by the false belief that the random numbers of a small sample will balance out the way they do in large samples; this is known as the law of small numbers heuristic. The difference between this and the hot-hand fallacy is that with the hot-hand fallacy an individual expects a run to continue.
There is a much larger aspect of the hot hand that relies on the individual. This relates to a person's perceived ability to predict random events, which is not possible for truly random events. The fact that people believe that they have this ability is in line with the illusion of control.
Well, what does all this means and affect our investment decisions making? With all these illusions of control, we tend to believe that the " hot-hand " fund managers with good performance will continue to be good while in fact, the past performance shall not have any influence or guarantee on their future success.
As for the "gambler's fallacy ", we might think that after seven years of the bull market since GFC, the market is ready or time for another major correction soon (recently many experts are forecasting huge market correction in 2017 ), but again in actual fact, if the market did collapse in coming months, it is all by random and not related to past events at all.
Also, remember what John Maynard Keynes said " The market can remain irrational longer than you can remain solvent. "
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