Originating from US basketball, the concept of having a hot hand hinges on the belief that the chance of hitting a basket is greater following a hit than a miss. In investing, it means believing you have a greater chance of success after completing a series of successful trades.
When applied to stock market investment, a hot hand investor would expect to be rewarded for a new investment decision based principally on the fact that their previous investment was profitable. As a trader, you might feel you are ‘on a roll’, however, studies show the hot hand is a misperception of chance in random sequences.
The reality is that there is no positive correlation between successive shots in basketball and the success of your next trade on the markets has no relation to the success of your most recent trades. You do not have a hot hand.
Averaging up, or pyramiding
Hot Hand thinking can often be linked with what is termed averaging up. Often referred to as ‘pyramiding’ this is when, after buying shares in a company, you buy some more as the price gets higher.
The hot hand bias may be persuading you to see only the upside, even though the share price has already risen significantly. Rather than buying low and selling high, by averaging up you are continuing to buy while prices are no longer ‘cheap’.
This strategy is not necessarily flawed, though, as the stock in question may indeed continue to rise significantly with the investor making a greater profit. But make your choice to continue investing based on research not your hot hand.
Similarly, if you are going short on asset you can continue to increase your positon as the price falls, but do so the basis of serious analysis of the reasons and likely continued fall in that asset’s price. Don’t believe it must continue to fall just because you picked it.
Identifying growth potential
What is an accurate definition of ‘cheap’ anyway? Is it in relation to historic valuations, or sector comparisons? What if the company in question has completely changed its business model or been a major disruptor in its sector? Do historic valuations always offer meaningful insight?
Just because a share price has doubled in value, does that mean it is time to take profit? Many companies (particularly smaller cap) have the potential to double their share price and then double it again…..and keep going.
For instance, in 2016 WeightWatchers saw its share price more than quadruple, with subscriber numbers boosted by the support of celebrity investor Oprah Winfrey.
Another company to quadruple its share prices was Esperion Therapeutics, a developer of drugs to treat cardiovascular disease. Positive drug trials in the US resulted in a soaring share price.
Benefits of averaging up
The advantage of averaging up in these instances, is that the investor is still in the game as the share price rises. As long as research and logic are the guiding principles and not the hot hand theory, averaging up can be a useful tool for traders.
Going back to the pyramid concept, the initial shares purchase is the wide base, then the pyramid gets narrower with subsequent buys. The ‘pyramid’ term relates to the fact that each time you buy more shares, you are buying a smaller number for same size stake.
Averaging up in this fashion ensures that your average cost doesn’t run up too fast, while still boosting your position in a potential winner. Essentially, you start a position and buy more in decreasing increments until after four or five buys, you have your full position size.
Let’s say you’d like to own 500 shares of ABC & Co but rather than buy the whole 500 in one go and hold them; you purchase 300 shares and add to them as they show a profit until you reach your optimum 500 shares. If the initial trade doesn’t work out, risk has been limited as you’ve not bought a full position size. There is less exposure to a falling stock.
It is all about timing
The big decision for every trader is when to average up.