What is the Gambler’s Fallacy?
A common false belief among novice traders is that after a series of losing trades in the market, the probability that the next trade will be a winning one increases. Therefore, they believe that the best way to recoup losses and make a profit is to increase the size of their positions on each subsequent trade. This is a fatal error and is known as the “gambler’s fallacy” because it is based on the assumption that past trades affect future trades, which is not true. We must not forget that each trade is a unique and distinct event that has no relation to previous trades. Therefore, past results, regardless of whether they were good or bad, do not affect future results at all.
Our recommendation is that you do not fall into this error, as it is based on an idea with no real basis. It is simply our psychology making us believe something totally false. To understand how psychology influences a trader’s performance, we will look at an experiment conducted at an American university known as “The Ralp Vince Experiment”.
It was conducted by an investor named Ralph Vince, which demonstrates the importance of money management, and how investors can lose money, even if they know they have a winning system.
The experiment was conducted with 40 professionals, with university degrees but no knowledge of trading. They were given a video game with $10,000 that replicated a winning trading system and were told that the game was designed to win 60% of the time, and that they would make a loss the remaining 40%. The game was easy: make 100 trades.
Once the experiment was over, the result was: 2 participants managed to make money. 95% of the participants lost money despite knowing how many winning trades they would have.
How can this result be explained if they knew how many trades would be positive and how many negative? The answer is: poor management. Knowing that there were a certain number of winning trades, after a few losing trades, participants expected the next one to be a winner by putting in more and more money. This shows that when you do not follow the management rules you should set for yourself, the results will be random and more detrimental than if you had used correct management.
This is the secret of successful traders: a proper trading strategy based on money management that allows them to put the odds in their favour and not a “foolproof system” to win because it does not exist.
As soon as you start trading the market, you should start applying money management. Even before that, in your demo tests, as you will replicate that in your live account.
The mistake of not applying money management until you test your trading system and see if it works, can be a very expensive mistake, literally. Mistakes in the stock market are paid for with money.
Money management principles and strategies are independent of the system used to trade, as well as the market or financial instrument. To apply a money management strategy, the first thing you need is the net result of a series of demo trades (it doesn’t matter if the results are from a trend following strategy, or if the instrument is a stock or a futures contract, as it is all about numbers, mathematics and statistics).