How to avoid the Gambler's Fallacy
While most people like to think that they are rational, most humans aren't very rational. Especially when money is on the line and time is scarce human decision making can be very flawed. Trading is one of the fields where erroneous and irrational behaviour patterns are especially common. In this chapter we're going to look at the most common cognitive biases and irrational decision making patterns and how to avoid them. Being aware of these thinking flaws has two main advantages. Firstly, it helps you avoid them in your own trading and secondly it can help you identify and explain seemingly irrational market behaviors caused by these biases. Most of these so-called cognitive biases were discovered and introduced by the Nobel winning Daniel Kahneman and Amos Tversky. The first cognitive bias that I want to talk about is the gambler's fallacy. The gambler's fallacy is incorrectly over or understating the likelihood of an event based on a series of past events. This can be illustrated with a simple example of a coin flip. The probability that a coin will land on heads is 50%. No matter how often you flip a coin this probability does not change. So even if your coin just landed on heads 10 times in a row, this does not affect the probability of the next coin flip. Like the name implies, the gambler's fallacy is especially common in gambling. But this pattern of thinking is quite common in trading as well. Let me give you some examples. Have you ever opened a long position because a stock had many consecutive down days or vice versa? If so, you have fallen prey to the gambler's fallacy. Another example would be the reaction to a losing or winning streak. If you ever felt that after many consecutive wins the chances of losing increased and you decreased your position size, you have been guilty of the gambler's fallacy. The odds of winning on a trade, don't magically change just because you had multiple losses or wins before this trade. Speaking of winning streaks if we assume that you found a trading strategy that guarantees you a 70% chance of winning on every single trade, what do you think the odds of winning 10 times in a row are? Well, the answer is under 3%. In fact, even the probability that you will have two consecutive wins with this strategy is under 50%. This means it is less likely that you will have two consecutive winners than that you won't. And remember, this is with a strategy that guarantees you 70% chance of success on each trade. Most strategies won't have nearly as good odds. To calculate the probability of “n” consecutive wins you simply have to take the estimated odds of your trading strategy to the power of “n”.
Note that this assumes that the trades are independent from each other and the probability of winning is constant. If we look at the odds of losing streaks we get a similar picture. Here's a diagram that shows the probabilities of multiple consecutive losses with a trading strategy that has a 40% chance of losing on any single trade.
As you can see with a 40 chance of losing it is extremely unlikely that you will have more than a handful of losses in a row. So what can we learn from this? Firstly no matter how good your strategy is, losses do happen. You can't win all your trades. Therefore you have to implement solid risk management practices and keep the size of your losses under control.
The odds of having many losses or wins in a row is quite low. So if you often have more than 10 major consecutive losses, you should seriously start doubting the quality of your trading strategy. But always remember, even though the probability of winning 10 trades in a row is very low, the probability of winning on any single trade is not lower just because you won on the last 10 trades.
