Monte Carlo fallacy, popularly known as Gambler’s fallacy, is an erroneous way of thinking named after a famous casino Monte Carlo. Accordingly, the fallacy poses a case where people believe that a past event will greatly affect the probability of something happening in the present or the future.
To illustrate the fallacy, imagine tossing a coin five times. Given the first and third attempts show the head and the second and fourth show tail, people with this fallacy might strongly think that the fifth can possibly be head instead of tail although the probability remains 50:50.
Another example with coin tossing works in contradiction. For example, a person has to toss a coin five times to spectate whether they majorly result in either head or tail. When the first four results in the head, the person has the fallacy if he/she thinks that the last one must be tail.
In sum, Monte Carlo fallacy is an error to understand probability which applies human’s way of thinking to the way everything works. Instead of working by remembering like human brains, coins do not remember anything. The fallacy, however, suggests that the coin indirectly follows a pattern it remembers to some extent.
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Monte Carlo Fallacy and Its Effect on Trading
In trading, Monte Carlo fallacy is among common trading fallacies in which many traders experience. This trading fallacy is dangerous as it deviates traders’ minds from rational thinking due to association with the past.
The inept way to think rationally due to the fallacy is influencing traders’ way to observe the market. In stock markets, for example, traders with Monte Carlo fallacy predict the next turn of the market by looking at odds in the past and invalidates other factors.
Furthermore, Monte Carlo fallacy is hard to detect while trading as it resembles observational thinking. However, there is a distinct component in a way to perceive probability and generate a decision following particular market conditions.
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Avoiding the Fallacy while Trading
To avoid the wash-back effect of the fallacy, there are three methods in which traders can follow.
Firstly, traders should always remember that stock markets do not work similarly to human memory. Thus reflecting upon the existing data at all times possible is a necessity. Reviewing trading journals are among the way to consult data.
Secondly, using the service of trading robots helps avoid fallacy. It, accordingly, eliminates second thoughts, emotional interventions, and other human errors. While this might take all the fun in trading, this is recommended for traders who orient to making profits.
Thirdly, learning to familiarize the minds with the markets is a good way to prevent the fallacy from occurring. To habituate the mind, trading using a demo account to grasp how the market works is a great option.
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