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Gambler's Fallacy

Research Paper

on

Gambler’s Fallacy

(16th August, 2009)

Submitted by:

Prashant Sahu

Index

Gambler’s Fallacy…………………………………………………………………………………3

Explanation of the bias…………………………………………………………….………………3

Studies………………………………………………………..……………………………………4

Explanations for the Bias………………………………………...………………….…………….6

Implications for Investment Decisions……………………………..……………………………..7

Active Investing……………………………………………..……………………………8

Fund Flows……………………………………………………..…………………………9

Equilibrium………………………………………………………………………………..9

References…………………………..……………………………………………………………11

Gambler’s Fallacy

The gambler's fallacy, also known as the Monte Carlo fallacy or the fallacy of the maturity of chances, is the belief that if deviations from expected behavior are observed in repeated independent trials of some random process then these deviations are likely to be evened out by opposite deviations in the future. For example, if a fair coin is tossed repeatedly and tails comes up a larger number of times than is expected, a gambler may incorrectly believe that this means that heads is more likely in future tosses. Such an expectation could be mistakenly referred to as being "due". In other words, gambler’s fallacy is the mistaken belief that random sequences should exhibit systematic reversals. An individual who holds this belief and observes a sequence of signals can exaggerate the magnitude of changes in an underlying state but underestimate their duration.

The gambler's fallacy implicitly involves an assertion of negative correlation between trials of the random process and therefore involves a denial of the exchangeability of outcomes of the random process.

Explanation of the bias

Faced with a streak of events and the necessity to make a choice, people may make one of three possible inductions: (1) that the streak is...