Behavioural finance: player's error

When it comes to probability, a lack of understanding can lead to incorrect assumptions and predictions about the beginning of events. One of these erroneous assumptions is also known as the player's illusion or "gambler's fallacy".

In gambler's fallacy, the trader mistakenly believes that the occurrence of a random event is less likely to occur following a specific event or series of events. This line of thinking is incorrect because past events do not change the likelihood that a specific event will occur in the future.

For example, consider a series of 20 flips of a coin that have all fallen on "heads". With gambler's fallacy, a person might predict that the next draw will be more likely to land on "tails". This line of thinking represents a misunderstanding of probability because the probability of a heads or tails result is always 50%. Each flip is an independent event, meaning that all previous flips have no impact on future ones.

Another common example of player's error can be found in the relationship people have with slot machines. We've all heard about players staying on the same machine for hours. Most of these people believe that every losing attempt brings them closer to the jackpot. These players don't realize that slot machines are programmed so that the chances of winning a jackpot are always the same (like the flip of a coin), the odds of winning are still the same even if a machine has recently paid out a jackpot.

The player's illusion in terms of trading

It isn't hard to imagine that in certain circumstances investors or traders can easily fall prey to player's error. For example, some investors think that they have to cash out a position that has just benefited from several series of increases, because they don't think that the rise is likely to continue. Conversely, other investors cling to a stock that has fallen over several trading sessions, because they think that a further decline is "unlikely".

It is important to understand that in the case of independent events, the probabilities of a specific outcome on the next trading session remain the same regardless of previous events. Buying a currency pair because you believe that an extended downward trend is likely to reverse at any time is irrational. Instead, investors should base their decisions on fundamental data and/or technical analysis before trying to determine what will happen to a trend.