The Gambler’s Fallacy: Key for Trend Following?

“It is a common notion that after you have profits from your original equity, you can start taking even greater risks because now you are playing with their money. We are sure you have heard this. Once you have profit, you’re playing with their money. It’s a comforting thought. It certainly can’t be as bad to lose their money as yours? Right? Wrong. Why should it matter whom the money used to belong to? What matters is who it belongs to now and what to do about it. And in this case it all belongs to you.”
William Eckhardt

The gambler’s fallacy and concept of availability error are key for traders. Trend followers have an understanding of these concepts built into their trading style.

The Gambler’s Fallacy

One of the easiest mistakes to make with trading is thinking that past trades influence future ones. This common mistake is sometimes called the gambler’s fallacy, and it often leads people to bet more money and to bet more often than they otherwise would. For example, many people know how to figure that there is only a one in sixteen chance that a fair coin will come up heads four times in a row. But if the coin has already come up heads three times in a row, then the chances that it will do so a fourth time are the same as they would be if it had never been tossed before–one in two. However, it is easy to make the mistake of thinking that this coin has only a one in sixteen chance of coming up heads. It seems that the coin should make the average of past tosses come out right. But in reality, the coin does not remember past tosses and feels no obligation to even out the number of heads and tails that have come up before. As we make more and more coin tosses, the ratio of heads to the total number of tosses will approach one half, but this does not mean that there will be exactly (or even close to) the same number of heads as tails, nor does this mean that in the course of a few tosses things will come up anywhere near even.

Misunderstanding this fact leads many traders to believe they have more information than they really do, and can cause them to be more willing to over-trade than they otherwise would.

Availability Error

The second major mistake people make, and which increases their tendency to over-trade, is called availability error by psychologists. This is the common tendency we all have to focus only on good, unusual, or easily remembered experiences, forgetting the bad, common, or less available ones. For example, hearing that someone has won the lottery sticks in our mind more than hearing that someone has lost the same lottery. We remember winners more than losers, and mistakenly think that the chances match our memory. This explains why people put more money into slot machines that are in large groups, where they can hear and see signs that others are winning, rather than into lone machines, where they have no recent memory of someone’s winning. And people consistently do this, despite the fact that the odds are just as bad for the group as for the lone machine. Memories of winners are simply more available for the large groups than the loners.

We may also think that if we know or have heard of a winner it must not be very hard to trade successfully. Many people have a story about how their Aunt or their brother-in-law’s boss’s friend once won on some great trade. But there are several things that are omitted from such stories. Most important is the fact that someone lost thousands of dollars before and after making that great trade. Many so called great trades are really only small wins that barely cover the cost of trading, and which serve to entice people to continue trading and losing more money. The markets take advantage of our tendency toward availability error and exploit our memory of the one great trade while encouraging us to forget the many losses.

Moreover, when we hear the story of our brother-in-law’s boss’ friend’s great trade, we tend to assume that because we have heard of this person and have some connection to him or her, however remote, and winning must be more likely than we had thought. But we never hear the story of our co-worker’s Uncle who lost fifty thousand dollars in the market gambling on tips with no strategy. And if we wanted to hear all the stories of the times that our relatives’ acquaintances’ friends or our friends’ acquaintance’s relatives lost money while trading, we would have no time for anything else. Indeed, by such a chain of associations you can hear the story of essentially every other person in the entire world.

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