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Monte Carlo fallacy, more popularly known as Gambler’s fallacy, states that a winning or losing streak is finite and has to end at a certain time. However, this idea is not supported by the facts. Statistics state that in probability; the outcome and timing the end of the event is unpredictable, a lack of understanding can lead to false assumptions and predictions about the onset of events.
For example, let's say you make a bet on whether India cricket team will win or lose the next test match. You bet that they will win, and your bet turns out to be right. Before the second game, you bet again that the team will win, and you turn out to be right once again. This continues four more games, and now the India team has won 6 games in a row. 6-0
Now you start thinking, what are the chances that the Indian team will win seven times in a row? The next one has to be a loss; hence you place a bet against the team. But the team wins again.
It's natural to see that string of wins and think that the streak can't go on forever and bet against it. But that's the gambler's fallacy. In reality, each win has nothing to do with the previous wins. That is, the first test win has absolutely no bearing on the team’s results in the 4th or 6th test match. So, it's perfectly rational to continue betting on wins if that's what you are inclined to do and that what your studies say.
Traders with this attitude may see Nifty or a stock move up for seven days in a row. They assume that day eight the stock will close in the red. Their instinct is that the streak can’t go on forever, that the odds are in their favor to short the security.
Or say that a stock has been going down for the past five months. They feel that it has to go up in the sixth month. This idea is not based on solid evidence. It’s based on the feeling that “it’s time” for the market to go up.
In the above chart of Nifty Futures a novice trader has a bearish view on the market, after Nifty has moved from 7800 to 9500. He places a short position on every rise 3 times in a row and on all 3 occasions his stop loss gets triggered. The trader tends to believe that his streak of losses will come to an end in the next trade and once again takes a short position this time increasing his position size in order to recoup his previous losses only to see the stop loss triggered once again.
In reality, when you are dealing with probability i.e. random draws, the odds of making a profit or loss on the 4th trade is the same as it was when you placed your first bet. Just because you have made a series of losses, the odds of making money on your next trade do not improve.
Traders fall prey to Gamblers fallacy and often end up increasing their bet sizes in order to recover their past losses without understanding how the odds stack up. Gamblers fallacy tends to ruin position sizing and our trading plan playing a big hand in wiping out our capital.
Gamblers fallacy works when the trader is on a winning streak as well.
Traders shouldn’t make decisions based on the belief that a winning or losing streak “just has to end.” Instead, they should take decisions on solid technical or fundamental research done by them or data obtained.
Going back to the Nifty example, let’s say there are good reasons to believe the domestic markets will continue to stay strong. In that case, it doesn’t matter if Nifty has gone up five days in a row, or even five months, or even a few years, in a row. The winning streak should not be a factor in taking a contra position. Rising markets can continue to rise, while falling markets can always fall further.