Investment psychology - gambler's fallacy
When flipping a coin, what are the chances of it landing heads up? It's a 50-50 chance. This is easy to understand, the most basic probability theory.
Suppose you flip a coin 5 times. Each time it lands heads, what is the probability of getting heads after 100 flips?
It's still a 50-50 chance. The previous coin flip results of heads or tails have no influence on the next coin flip outcome.
Each coin toss is an independent act.
Those who fall victim to the gambler's fallacy will place their bets on the flip.
The gambler's fallacy is a mistaken belief that if something happens less frequently than it has in the past, it will happen more often in the future.
If heads don't appear in the first five coin flips, then the sixth coin flip must result in heads. In other words, heads are due!
By flipping a coin, we are less likely to fall into this trap.
But when it comes to trading, the situation is different.
Let's replace "tails" with "losing trades" and "heads" with "winning trades".For simplicity, let's assume there is a 50-50 chance of winning a trade.
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Suppose you have five consecutive losses. You might think that your next trade is more likely to be a winner.
Perhaps you would increase your risk to make up for previous losses.
The reality is that the outcome of your next trade is not influenced by previous trades.
The market does not remember or care what your last trade was.
The gambler's fallacy can lead us to close winning trades too early and let losing trades drag on for too long.
Suppose you make a trade that loses money. Now you think it's less likely to lose again, so you keep holding on to the trade.
Unfortunately, this can lead to more serious losses.
Or, suppose the trade you made is profitable.
You close it quickly because you think it's unlikely to gain further.No matter what, the profit in hand feels good.
But now you might be giving up potential future gains.
How can you avoid the gambler's fallacy?
(Most importantly, by creating and sticking to a trading plan)
Your trading plan should clearly specify when you exit a trade (such as stop losses and profit targets).
This way, you won't be tempted to hold onto losing trades for too long, nor will you exit winning trades too quickly.
Your trading plan should also ensure that you don't consider previous losing trades when making the next one.
You won't take on greater risks in an attempt to recoup losses.
Traders fall victim to the gambler's fallacy because their emotions get involved.
This leads to a lack of discipline.(Possibly the biggest reason for individual investors' losses)
If you find yourself in this situation, try to identify the root of the problem.
Perhaps you have taken too much risk by investing too much money in the stock market;
or you constantly worry about whether your portfolio is effective.