What is Gambler's Fallacy?
The gambler's fallacy is a situation in which a gambler believes that a string of past events will change the probability of future events occurring.
How Does Gambler's Fallacy Work?
Coin flips are the most common example of the gambler's fallacy. For instance, in a game of heads or tails, many people will bet on tails if there have been several heads in a row. But the concept applies to other forms of gambling and, in turn, investing.
For example, let's say you make a bet on whether your favorite football team will win or lose. You bet that they will win, and you're right. Before the second game, you bet again that the team will win, and you turn out to be right. This continues five more games, and now the team is sitting 7-0.
You start thinking, what are the chances that this team wins seven times in a row? The next one HAS to be a loss, you think, so you bet against the team. But the team wins again.
It's natural to see that string of wins and think that the streak can't go on forever. But that's the gambler's fallacy. In reality, each win has nothing to do with the previous wins. That is, the first win has absolutely no influence on how the third or the fifth game will turn out. Accordingly, it's perfectly rational to continue betting on wins if that's what you're inclined to do.
Why Does Gambler's Fallacy Matter?
If you substitute 'stock' for 'football team' in the above example, you'll see why the gambler's fallacy is prevalent in investing, where investors often think that when a stock is reporting positive earnings quarter after quarter or its stock price is climbing day after day, that the 'streak' can't go on forever. Consequently, many investors believe that yesterday's events will determine today's events and start to sell the stocks in those situations. In reality, they may be getting out too soon.
