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What is the Gambler’s Fallacy?
The term gambler’s fallacy refers to the belief that individuals have that the probability of a random event occurring in the future depends on the previous instance of that type of event. Another name used for the gambler’s fallacy is the Monte Carlo fallacy. It occurs when individuals believe that the outcome of a single or several historical events influences the consequence of another event in the future.
When influenced by the gambler’s fallacy, individuals tend to put overreliance on the outcome of historical events. They believe that if an event has occurred frequently in the past, it will happen again in the future. However, these outcomes are usually random and not influenced by historical events. As the name suggests, the gambler’s fallacy is prevalent among gamblers.
How does the Gambler’s Fallacy work?
In theory, for events that have a random outcome, any historical results should not be influential. Hence, making predictions based on historical results is futile. Despite that, individuals may try to establish patterns even when none exist. Based on this, they end up making decisions although they understand the randomness involved with the event.
The gambler’s fallacy stems from the misjudgment that investors make on a random event’s outcome. Usually, the belief that random events are not truly random and may demonstrate some patterns or trends. Mostly, they use short-term information to establish this belief. In the long-term, however, investors suffer from losses due to basing their decisions on wrong opinions.
How can the Gambler’s Fallacy affect decision-making?
The gambler’s fallacy tempts individuals to establish patterns and trends for random events. Therefore, it leads to wrong decisions made by these individuals. On top of that, by discovering such non-existent trends, individuals are likely to ignore any information opposing their beliefs. Therefore, they end up making losses when their predictions fail to realize.
In some cases, a casual relationship between two events may exist. However, when individuals overanalyze this relationship, they establish a stronger dependence than what is actual. Based on this, they make decisions related to the future that involves using selective historical information. Usually, this decision follows substantial losses for individuals based on the extent of their decision.
The gambler’s fallacy can also affect investors and financial decisions. For investors, having accurate and complete information about their investments is crucial. When they fail to realize that two investments are statistically independent, they will make wrong decisions. In that case, they end up suffering losses.
How to avoid the Gambler’s Fallacy?
The primary response to the gambler’s fallacy is considering more information. One of the reasons this bias may exist is the lack of information that individuals let influence their decisions. By analyzing all available information, individuals can determine the relationships that exist between historical and future events.
Similarly, establishing independence between two events also helps avoid the gambler’s fallacy. It is possible to do this by either considering all information or using the critical thinking process. Individuals must also establish the reason why they believe a past event may bear a relationship with a future one. By doing so, they can recognize if they are allowing the gambler’s fallacy to impact their decisions.
In most decision-making processes, establishing a relationship between two events is crucial. However, some people may put an overreliance on a relationship when none exists. It primarily stems from the gambler’s fallacy, which occurs when individuals believe the probability of a random event in the future depends on another historical event.
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