Gambler’s fallacy happens when you let a previous independent event change your thinking on future outcomes. For example, let’s consider the flip of a coin. There are two possible outcomes… heads or tails.
Each outcome has a 50% probability of happening. No matter how many times you flip the coin, there’s still a 50% probability of either heads or tails. But here’s the problem, people let the previous flips impact their guesses on the next flip.
Let’s say heads shows up the first three times you flip the coin. People falling prey to gambler’s fallacy are then more than 50% likely to guess heads on the fourth flip. But that’s illogical. They let the recent pattern influence their next decision. It’s a clear example of recency bias and gambler’s fallacy.
No matter how many times you flipped the coin before, the next flip is still a 50% probability of either heads or tails. And for a trick question, can you come up with an example of why a coin flip isn’t 50-50 in the real world? Let me know in the comments below.
Either way, it’s easy to see how gambler’s fallacy works with the flip of a coin… but it can become much more complex. When it comes to casino card games, tracking the probabilities is more challenging. In that context, gambler’s fallacy is also called hot hand fallacy. A recent winning streak can impact how people bet going forward… even though the underlying probabilities don’t change and they won’t win on average.
Going one step further and one of my favorite sayings… don’t confuse a good outcome with a bad decision. Just because an outcome works out in your favor, it doesn’t mean your decisions leading up to it were good.
With investing, I’ll sometimes see new investors win big on their first trade. And that’s great! They might even rack up a few winners in a row starting out. But in worst case scenarios, they become overconfident due to the recent wins and increase the amount they invest. Although, their winning streaks don’t often persist. Eventually their strategies (or lack thereof) stop working.
I hope my explanation and examples of gambler’s fallacy help. If you found them useful or thought-provoking, feel free to let me know in the comments below. Also, if you have any questions, please let me know as well.