What is the “Gambler’s Fallacy” and how might it describe why you may not be achieving the trading results you’ve been expecting?

According to The Skeptic’s Dictionary, the Gambler’s Fallacy is the incorrect notion that the odds for something with a fixed probability increase or decrease upon observing the most recent occurrences.

The classic fallacy plays itself out on the Roulette wheel, when the ball has landed on a red number 4 or 5 times in a row, and gamblers believe that red is now “hot” and so they place their bets more frequently on red, even though the fixed chance of red coming up is 47.5%.

Roulette wheels take advantage of this fallacy by posting the most recent numbers and colors on flashy boards near the roulette wheel.  It causes gamblers either to say a certain number or color is hot or cold, and so they irrationally adjust their betting strategies to accommodate this perceived (though false) edge.

Similarly, if a fair coin has been tossed numerous times and the last 4 throws have been heads, then a better commits this fallacy one of two ways:

1)  By betting heads because he expects heads to come up because it has come up the last 4 times in a row

2)  By betting tails because he expects tails to come up because it has NOT come up in the last 4 throws and he feels it is “due”

Notice that expectation plays a major role in committing the fallacy.  In reality, the outcome of the probability is 50%.

In trading, there are plenty of chances to commit this fallacy, but note that the odds and probabilities in trading are not actually fixed, but often change, which complicates the situation.

However, if your strategy has a certain, discerned edge, then you can create this fallacy the same way if you adjust trading size or expectations significantly based on the results of your last three or four trades.

If you know your trade set-up (or strategy) has a 60% win rate, and you have just experienced 7 winning trades in a row, you would commit the error by doubling your position size because you expect the next trade also to be a big win, or cutting your size in half because you expect the next trade to be a loser because 7 trades in a row is just too good to be true.

The key is to know your probabilities, stick to a certain ‘betting style’ or method of selecting trades (that you know have an edge), and continuing to let the probabilities play themselves out naturally, rather than trying to step in and tweak them whenever you feel either frightened or unstoppable.