The World of Investments and Money

Monday, May 28, 2007

Gambler's Fallacy

There are people who see patterns in random data and try to predict the future based on such patterns. Probability theory states that for an unlimited set of trials, the numbers in a game should come up equally or the same number of times.

For example, a coin when flipped a given number of times, should have equal number of heads and tails. So, if the coin has been flipped 5 times and the outcome have been head, head, tail, head, head, the outcome has not been what was perceived. A person might assume the chance of the next outcome being tail is more as it has only occurred once in the last five tosses. The reality is that the next toss has equal chance for tail and head, both have 50% chance. The past events don't mean anything for the future outcome. But, the person thinks there'll be an unknown self-correction that will skew the results in favour of tail to make it more balanced as per probability theory. This belief is known as the gambler's fallacy.

There are similarities in such beliefs with trading. Predicting the price change at any time is like flipping a coin. Most of the patterns that are found are a result of the random data searched. These patterns are not likely to repeat in the future. They can't be used to make predictions. But people often make such predictions and others fall for them.

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