What Is Gambler’s Fallacy And How To Avoid It?

Decision making, and especially financial decision making often requires a lot of mental energy due to the complex decisions, full of complex information. Gambler’s fallacy is a cognitive bias that we can fall into when making those decisions, often leading to poor results.

What is Gambler’s fallacy

Gambler’s fallacy is a belief that we can assign probability to random events based on past similar events.

This is because in general, us people don’t like randomness or unpredictable things, so we try to create order and patterns even where they don’t exist.

We will easily believe that there is a relationship between events (that X happens because Y happened) even when there is no relationship (Y didn’t have anything to do with the fact that X happened).

This can happen because of the above reason, we want to see patterns even when there isn’t any, but also because our sample size, from which we draw conclusions, is often small not giving us the full picture.

Small sample size might make us see patterns, or cause and effect relationships, where there is none, because it might look like they exist based on what we can observe.

True randomness is often truly clear from a large sample size.

For example, gambler’s fallacy is when you play the same lotto numbers over and over again, believing that the odds of them being right the next time you play increase every time they are wrong, so you won’t change them.

How to avoid it

Gambler’s fallacy is quite hard to fully eliminate because our desire to make sense of our surrounding world is deeply ingrained.

We simply want to have a reason for things that happen and will land on something, whether it is true or not.

What helps is to be aware of it.

Question your beliefs of why something will happen next, is there any real evidence of a cause and effect relationship between two things or are they random, completely unrelated?

Gambler’s fallacy in personal finance

Gambler’s fallacy in personal finance can be the reason behind poor investment decisions.

For example it can lead you to sell high (because you believe that since the share in question has been going up in value it will soon drop in value), or makes you hold on to poor investments that are losing value as you believe that they will start growing soon.

But, in reality we need to look at each individual decision on their own merit, and not rely on past to try to predict the future.

You can read more about this bias here.

Have you been caught up by gambler’s fallacy?