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Gambler’s fallacy in trading is an irrational belief that the price of a stock or cryptocurrency will reverse its upward or downward trend because a correction is overdue.
In such cases, the trader thinks that the probability of a certain event occurring is solely based on the occurrence of previous independent events.
Researchers believe that when investors are faced with decision-making that requires significant time and effort, they turn to a subjective and suboptimal path of reasoning.
In this article, we explain gambler’s fallacy in trading and explain how to avoid it.
Key Takeaways
- Gambler’s fallacy in trading occurs when a person makes irrational investment decisions.
- Traders depend increasingly on luck and chance when they exhibit Gambler’s fallacy.
- Hot hand fallacy, the opposite of gambler’s fallacy, is the belief that a person with an ongoing string of positive results will see continued success.
- To avoid the gambler’s fallacy, traders must practice disciplined investment practices.
What Is Gambler’s Fallacy in Trading?
Amos Tversky and Daniel Kahneman first identified this behavioral bias in 1971. In trading, the gambler’s fallacy can cause traders to exit a profitable position too soon or hold onto a losing one for too long.
It differs from the hot hand fallacy, where traders believe that a winning trend will continue with no rational reasoning behind it.
Outside trading, Gambler’s fallacy is also known as the Monte Carlo fallacy after the behavioral bias was observed among gamblers at the Casino de Monte-Carlo in Monaco in 1913. At the Monaco-based casino, gambler’s fallacy took place at a roulette table, when the ten consecutive spins landed on a black slot.
Cognitive bias took over as gamblers thought a red was long overdue after seeing consecutive black slots. They started betting against the black. The black trend continued, reinforcing the gambler’s fallacy that the next ball would land on a red slot.
Only after 26 consecutive blacks did the ball finally land on the red. By then, gamblers had lost in multifolds while the casino profited from the gambler’s fallacy.
Gambler’s Fallacy Examples in Trading
Gambler’s fallacy is a common occurrence in financial market trading and investing. Investors and traders often fall prey to the gambler’s fallacy when predicting market movements based on past market performance.
Let’s say a Bitcoin (BTC) trader chooses to open a long position at the price of $50,000.
Bitcoin price sees five consecutive days of gains to hit $55,000. The trader believes that BTC’s winning streak is unlikely to continue and thus chooses to exit this position and book his profit.
Here, the trader makes an investment decision solely based on the probability of a random event occurring based on the occurrence of past events.
Here are two market scenarios that could follow:
1. BTC Price Uptrend Continues
Let’s say the Bitcoin uptrend continues, and BTC price reaches $63,000. In this scenario, the trader who exited too early will miss out on potential gains.
2. BTC Price Falls & Proves the Trader Right
If the price of Bitcoin falls the next day and breaks its five-day winning streak, the trader’s intuition is proved to be right.
However, it should be noted that his investment decision was not made on sound fundamental and technical analysis but on subjective and suboptimal reasoning.
Such an occurrence will only reinforce the cognitive bias in the trader’s mind.
Next time Bitcoin goes on a five-day winning streak, the trader may gain confidence from the successful prediction and short the asset solely based on this irrational investing bias.
In reality, the market is unpredictable. And you should base your investment decisions on a thorough fundamental and technical analysis.
Gambler’s Fallacy vs. Hot Hand Fallacy
Hot hand fallacy is a behavioral bias seen in investing, gambling, and sports.
Hot hand fallacy is the belief that a person with an ongoing string of positive results will see continued success.
Basketball fans will be familiar with commentators referring to a player who has made consecutive baskets as “hot.” Teammates will typically look to pass the ball to the “hot” player as they believe that he will continue to score without missing.
Similarly, traders with a “hot hand” may make investment decisions solely based on their recent trend of profitable trades.
The same concept is applicable if there is a series of failures referred to as “cold hand.”
In contrast, a gambler’s fallacy irrationally lets a person believe that a trend will reverse because it is long “overdue” and outcomes will end up “evening out.”
Why Traders & Investors Fall Victims of Gambler’s Fallacy
How to Avoid Gambler’s Fallacy in Trading: 5 Tips to Follow
To avoid gambler’s fallacy traders must practice disciplined investment practices such as conducting thorough market research, identifying entry and exit points, using stop-loss and limit orders, and recording investment decisions.
Conduct Market Research
Traders must conduct thorough research and due diligence before buying stocks, cryptocurrencies, and other financial assets.
Market research will help traders and investors make informed decisions and avoid impulsive actions.
Staying updated with the market will also allow investors to time their entry and exit, identify potential red flags, and spot undervalued opportunities.
Develop Self-Awareness
Cultivating self-awareness and staying mindful of your behavioral biases in investing is key to avoiding the gambler’s fallacy.
Keeping a record of your trades and analyzing them later can help you identify your behavioral biases in investing.
Think of why you made a certain investment decision and try to understand why you linked the occurrence of a past event to the probability of a future one.
Individuals who fail to recognize the independence of events will fall prey to the gambler’s fallacy.
Identify Entry & Exit Points
Instead of riding on luck and chance, investors must apply technical market analysis to identify entry and exit points.
Entry points are prices that are most favorable for a trader to enter a long or short position. Similarly, exit points refer to prices that will result in a profitable exit from a market position.
Experienced investors and traders use market indicators such as moving averages, Bollinger bands, support and resistance levels, relative strength index, and stochastic oscillators to time the market.
Using Stop-Loss & Limit Orders
Using stop-loss and limit orders is considered one of the best methods to prevent gambler’s fallacy in trading.
Stop-loss orders are sell orders that are executed automatically when the asset drops below a pre-determined price. Limit orders are used to buy or sell assets at a specific price or better.
A key advantage of using stop-loss and limit orders is that it prevents traders from making investment decisions based on emotions.
Instead, investment strategies are devised based on thorough research and executed using favorable entry/exit points, as well as limit and stop-loss orders.
Discussions With a Friend or a Mentor
Sometimes, discussing your investment history with a friend, mentor, or financial advisor can help you recognize your cognitive biases in investing.
An outside perspective could spotlight your irrational and impulsive investment decisions.
The best candidates for this role are those who are not afraid to point out your wrongdoing.
The Bottom Line
Gambler’s fallacy in trading can be detrimental to your investment goals.
As the word suggests, investors and traders exhibiting gambler’s fallacy may be depending on luck or chance instead of market research to try to profit from risky asset markets.
Always remember to conduct your research before investing. Past performance does not guarantee future returns.
