Gamblers Fallacy or Monte Carlo Fallacy
Gamble, Gamble. What comes into your mind when you hear these words? Casino and playing with your hard-earned money right! The place where people go and lose their money right? You might be partially correct on this as the majority of people lose millions of dollars gambling overnight. And with this, let me take you back to the year 1913 to Monte Carlo Casino in Monaco. What happened here showcased an ordinary behavior of a human turning to an extraordinary outcome.
The year is 1913 and people have started playing Blackjack. This is a gamer where you roll the ball into a spinning wheel and the ball will randomly fall into one pit. Here the people can either bet on the number onto which the ball falls or the color onto which the ball falls. Now, if you bet on the number and it turns out to be correct you get 32 times your betting amount. If you bet on the color you get 2 times your betting amount. The chances of the ball falling in either black or red is 50% and thus people see this as a safer side and most of them bet on this. The first draw the ball fell into the black pit and the people who betted on black won their money back. The next draw again the ball fell into black. Well, some people won again. This went on for 7 consecutive times now. And now, people started to think, it’s been 7 times in a row, the next will surely be on red, so I shall bet on red. But alas, the ball again fell into black. This went on, now on the 17th consecutive black pit, people believed yes, now is the time for reversal, the next should definitely be on red. What do you think happened? Black again. For 26 consecutive times, the ball fell on black and people who just waited for reversal (ball to fall on red) just kept on waiting and lost all their opportunities. Now for the 27th draw, the ball finally landed in the red pit. Think now. For 26 times straight it was black and the 27th time only red came. Why do you think this happened?
To make you understand this a bit easy, let me take you to a game of tossing a coin. A simple game, toss the coin and predict what is the outcome. Sounds simple right? But you need to know one factor here, each toss of a coin is independent of its previous toss. This means any previous toss doesn’t have any impact or influence on the next toss. Suppose I toss a coin for 4 times and I get 4 heads straight. Now you see a pattern, 4 heads in a row. The next will surely be tails. The heads had a good run. There are patterns everywhere and humans are good at recognizing patterns. There is a 50% chance of getting tails and a 50% chance of getting heads. This doesn’t say the 5th toss will end up in head. All the tosses are independent of each other. In mathematics, it’s called a mutually independent event. No matter what happens luck doesn’t come into play here.
Now think of tossing a coin and getting head and tail as getting black and red on the gambling table in a casino. So, even if we get 10 blacks in a row, the next outcome is totally independent of its previous outcomes. Even though the fact is this, people believed that after 10 blacks next will surely be red, after 20 blacks next will surely be red. This thinking, this mentality is called gamblers fallacy. Since it was first observed in Monte Carlo (remember our casino), it’s also called as Monte Carlo fallacy.
Let me give you some more examples:
Suppose you see lightning in the sky and then hear thunder, this makes you believe the thunder was caused by the lightning. Although some part of this is true.
What if you ate a good creamy pie and the next day you become sick? Was it because of the pie or rather something else? What do you believe?
While our brain sees these patterns, it takes science to prove them. Most of the previous research on Gamblers' Fallacy has focused on bringing people into laboratory settings and studying their behavior within those experimental settings. There is a human tendency that neurologists call apophenia that basically says the human universally looks for random bits of patterns. Apophenia is finding “patterns” that doesn’t really exist.
How do the casinos take advantage of this? You might have noticed the large displays which are attached to the roulette tables (gambling table) that show you the most numbers and colors that were hit. Turns out, a lot of people use these to actually predict which numbers are due in the coming rounds. But now you know this doesn’t work at all. Let me now straighten up the definition of gamblers fallacy for you. Gamblers Fallacy: A false belief that a random event is more or less likely to occur in the future based on how often it occurred in the past.
Now let me take you to the world of Financials and Investments. I assume you are into some kind of financial markets, be it in stock markets or personal finance. The biggest problem with the gambler's fallacy in a financial content is that it can lead to a false prediction about the future performance of an asset (stock). That is, if a stock has seen an increase in price for several days in a row you suddenly start to think that now might be a good time to sell because it is unlikely that this trend will continue in near future.
Or, this is the most popular one. If the stock is moving down for several days in a row, you might be reluctant to sell it because you think that the reversal is around the corner and anytime the stock can reverse in trend. But the truth is, you don’t know that and nobody does.
RCOM- Reliance Communication Share Price Graph
Let me take you to an example. Suppose you have invested in RCOM (Reliance Communication) in the year 2016. Well, 50 rupees is a good buyback in 2016 assuming you have analyzed the stock well. Few days after you have invested, you see the stock price falling down. What do you do? The majority will wait. They will wait for the price to reverse its direction (from downtrend to uptrend). But as you can see from the graph, waiting for a reversal wasn’t helping much. The price started to move down, down and down. If you were thinking of a reversal and holding onto it, the present value after 5 years is close to 2 rupees. Which means you have lost 96% of your capital. Let’s say, you had invested 1 Lakh in RCOM back in 2016, now you would will be sitting with just 4000 rupees. This is just one example, see companies like SUZLON, RNAVAL, etc to find similar patterns.
Well, now you got a fair idea on Gamblers Fallacy. The next question you might ask is what is it for you. What can I gain from this? The main idea first of all is to identify these patterns, recognize them and take actions based on them. Now you know why most of the gamblers lose money. In terms of investment, always put a stoploss, don’t let one stock eat a greater portion of your capital, always protect your capital and get out of the investment or the trade you’re into. You can trade only if you have a capital and no capital means no chance for trading or investment.
With this, I hope you have gained some insights on Gambler’s fallacy and how it affects common people like us and our thinking towards our day-to-day decisions.