Gambler’s Fallacy And Why It Matters In Business

Gambler’s fallacy is a mistaken belief that past events influence future events. This fallacy can manifest in several ways. One example, if how individuals mistakenly conclude past events. Instead, to prevent the gambler’s fallacy, business people need to know that the real world is more complex and subtle than a game, and rather than relying on complex models, they can rely on solid time-proved heuristics.

Understanding the Gambler’s fallacy

The Gambler’s fallacy is based on unsound reasoning. 

It is often seen in gambling, where an individual might predict that a coin toss will land on heads based on the previous three results of tails. In reality, of course, the probability of either result occurring does not deviate from 50%. That is, each coin toss is an independent event with no relationship to previous or future tosses.

Nevertheless, many individuals are influenced by this fallacy because they underestimate the likelihood of sequential streaks occurring by chance. This results in a cognitive bias where an event is judged based on unrelated factors within a very small sample size.

Mistaken beliefs arising from the Gambler’s fallacy manifest in two ways:

  1. The belief that if an event occurs more frequently than usual, it is less likely to occur in the future.
  2. The belief that if an event occurs less frequently than usual, it is more likely to occur in the future.

Other applications of the Gambler’s fallacy

In investing, the fallacy causes investors to believe that a company reporting successive quarters of positive growth is primed for a period of negative growth. Using this reasoning, the investor might pre-emptively sell shares in a company even though the fundamentals leading to growth have not changed.

The reverse is also true. In the case of a company experiencing several quarters of negative growth, an investor may endure large capital losses in the mistaken belief that a profitable quarter is imminent.

Studies have also found evidence for Gambler’s fallacy decision making in:

  • Refugee asylum court decisions. Judges were more likely to reject applications for asylum if they approved the previous application.
  • Loan application reviews. Loan applications were more likely to be reversed if the following two decisions were made in the same direction. 
  • Major League Baseball umpiring. Umpires were less likely to call a strike if the previous pitch was called the same way. The effect was amplified significantly for pitches closer to the edge of the strike zone or if the previous two pitches were called the same way.

In each of the three examples, it was found that less experienced decision-makers were more likely to underestimate the likelihood of event streaks occurring by chance – particularly when occurring in quick succession.

Avoiding the Gambler’s fallacy

Businesses that operate in industries prone to the Gambler’s fallacy should first ensure that decision-makers are experienced and knowledgeable in their given fields.

Awareness of the fallacy itself is also crucial – though research shows that awareness alone is not enough to prevent against being influenced.

De-biasing techniques are often effective. These techniques involve emphasizing the independence of events by highlighting their inability to affect each other. The emphasis can be internalized by remembering the classic fallacies of a coin toss or the roll of a dice. De-biasing can also include slowing down the reasoning process and removing distractions. This makes it easier for individuals to think logically, avoiding cognitive biases.

The concept of cognitive biases was introduced and popularized by the work of Amos Tversky and Daniel Kahneman in 1972. Biases are seen as systematic errors and flaws that make humans deviate from the standards of rationality, thus making us inept at making good decisions under uncertainty.
Bounded rationality is a concept attributed to Herbert Simon, an economist and political scientist interested in decision-making and how we make decisions in the real world. In fact, he believed that rather than optimizing (which was the mainstream view in the past decades) humans follow what he called satisficing.

Key takeaways

  • The Gambler’s fallacy is a cognitive bias where an individual mistakenly believes that past events influence the outcome of independent future events.
  • The Gambler’s fallacy occurs because of the underestimation of the likelihood of sequential events occurring by chance. As a result, it is seen in many industries where seemingly related events occur in quick succession.
  • Avoiding the Gambler’s fallacy starts with awareness and ensuring that decision-makers are highly experienced. De-biasing techniques can also be employed to reinforce logical reasoning and reduce cognitive load.

Connected Thinking Tools, Biases And Heuristics

As highlighted by German psychologist Gerd Gigerenzer in the paper “Heuristic Decision Making,” the term heuristic is of Greek origin, meaning “serving to find out or discover.” More precisely, a heuristic is a fast and accurate way to make decisions in the real world, which is driven by uncertainty.
The recognition heuristic is a psychological model of judgment and decision making. It is part of a suite of simple and economical heuristics proposed by psychologists Daniel Goldstein and Gerd Gigerenzer. The recognition heuristic argues that inferences are made about an object based on whether it is recognized or not.
The representativeness heuristic was first described by psychologists Daniel Kahneman and Amos Tversky. The representativeness heuristic judges the probability of an event according to the degree to which that event resembles a broader class. When queried, most will choose the first option because the description of John matches the stereotype we may hold for an archaeologist.
The take-the-best heuristic is a decision-making shortcut that helps an individual choose between several alternatives. The take-the-best (TTB) heuristic decides between two or more alternatives based on a single good attribute, otherwise known as a cue. In the process, less desirable attributes are ignored.
The concept of cognitive biases was introduced and popularized by the work of Amos Tversky and Daniel Kahneman since 1972. Biases are seen as systematic errors and flaws that make humans deviate from the standards of rationality, thus making us inept at making good decisions under uncertainty.
The bundling bias is a cognitive bias in e-commerce where a consumer tends not to use all of the products bought as a group, or bundle. Bundling occurs when individual products or services are sold together as a bundle. Common examples are tickets and experiences. The bundling bias dictates that consumers are less likely to use each item in the bundle. This means that the value of the bundle and indeed the value of each item in the bundle is decreased.
The Barnum Effect is a cognitive bias where individuals believe that generic information – which applies to most people – is specifically tailored for themselves.
First-principles thinking – sometimes called reasoning from first principles – is used to reverse-engineer complex problems and encourage creativity. It involves breaking down problems into basic elements and reassembling them from the ground up. Elon Musk is among the strongest proponents of this way of thinking.
The ladder of inference is a conscious or subconscious thinking process where an individual moves from a fact to a decision or action. The ladder of inference was created by academic Chris Argyris to illustrate how people form and then use mental models to make decisions.
The Six Thinking Hats model was created by psychologist Edward de Bono in 1986, who noted that personality type was a key driver of how people approached problem-solving. For example, optimists view situations differently from pessimists. Analytical individuals may generate ideas that a more emotional person would not, and vice versa.
Second-order thinking is a means of assessing the implications of our decisions by considering future consequences. Second-order thinking is a mental model that considers all future possibilities. It encourages individuals to think outside of the box so that they can prepare for every and eventuality. It also discourages the tendency for individuals to default to the most obvious choice.
Lateral thinking is a business strategy that involves approaching a problem from a different direction. The strategy attempts to remove traditionally formulaic and routine approaches to problem-solving by advocating creative thinking, therefore finding unconventional ways to solve a known problem. This sort of non-linear approach to problem-solving, can at times, create a big impact.
Moonshot thinking is an approach to innovation, and it can be applied to business or any other discipline where you target at least 10X goals. That shifts the mindset, and it empowers a team of people to look for unconventional solutions, thus starting from first principles, by leveraging on fast-paced experimentation.
Tim Brown, Executive Chair of IDEO, defined design thinking as “a human-centered approach to innovation that draws from the designer’s toolkit to integrate the needs of people, the possibilities of technology, and the requirements for business success.” Therefore, desirability, feasibility, and viability are balanced to solve critical problems.
The CATWOE analysis is a problem-solving strategy that asks businesses to look at an issue from six different perspectives. The CATWOE analysis is an in-depth and holistic approach to problem-solving because it enables businesses to consider all perspectives. This often forces management out of habitual ways of thinking that would otherwise hinder growth and profitability. Most importantly, the CATWOE analysis allows businesses to combine multiple perspectives into a single, unifying solution.

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