Averaging up and hot hand fallacy in trading

Originating from US basketball, the concept of having a hot hand fallacy hinges on the belief that the chance of hitting a basket is greater following a hit than a miss. In trading, it means believing you have a greater chance of a positive outcome after completing a series of potentially profitable trades.

When applied to stock market trading, 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, the hot hand is just 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.

Pyramiding is a way of increasing ownership of a stock as prices rise; Photo credit: Martin Gillman / Shutterstock

Hot hand fallacy: How does it look in trading?

What is the hot hand fallacy? Dr. Vicki Bogan, Professor and Director of the Institute for Behavioral and Household Finance (IBHF) at Cornell University, said that the hot hand fallacy is the unwarranted extrapolation of past trends in forming forecasts.

Making trading decisions based only upon recent information – for example, positive price performance – can lead traders to think current trends are the best predictors of what will happen next. However, they could miss the broader picture, disregarding longer term performance data, fundamental factors and macroeconomic events.

The research published in the Journal of Economic Behavior & Organization called hot hand fallacy an important behavioural bias in financial markets. Speaking of the hot hand fallacy in trading, it said that people affected by this bias misinterpret random sequences:
 

A simple example of hot hand fallacy in trading could be an erroneous belief that your next trade on the same asset that brought your profit last time will be profitable again.

Averaging up, or pyramiding

What is averaging up? 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 more as the price rises.

How does averaging up work? 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’.

Averaging up trading strategy is not necessarily flawed, though, as the stock in question may indeed continue to rise significantly. But make your choice to continue investing based on research not your hot hand and note that the stock can always drop unexpectedly.

Similarly, if you are going short on an asset you can continue to increase your position as the price falls, but do so on 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’? 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?    

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.  

For instance, the stock of a German biotech company BioNTech (BNTX) surged from around $10 at launch in 2019 to more than $380 at the peak of Covid-19 pandemic in August 2021, due to the success of the Pfizer-Biotech vaccine. 

However, the stock lost more than half of its value since then, trading at around $150 in August 2022.

Still, even if your trading decision is made on a thorough research, rather than a hot hand fallacy and averaging up strategy, past performance is not a reliable indicator of future results. Markets are volatile and the price of any asset can go against you, triggering losses. 

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 may make sense.

Going back to the pyramid concept, if 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 the same size stake.

Averaging up in this fashion ensures that your average cost doesn’t run up too fast, while still boosting your position. Essentially, you start a position and buy more in decreasing increments until after four or five buy positions, you have your full position size.

Let’s say you’d like to own 500 shares of ABC & Co, but rather than buying the whole lot in one go and holding them, you purchase 300 shares and add to them as they show a profit, continuing until you reach your target. If the initial trade doesn’t work out, risk has been limited, as you’ve not bought a full position size. 

Successful investing is a combination of diligent research and good timing. Photo credit: Garsya /Shutterstock

The downside of averaging up

Averaging up is not for everyone or for all occasions. There are disadvantages. For instance, transaction costs are higher due to higher frequency of trading. There will be more commission to pay on, say, four trades than just one. 

Not only do investors need to set aside cash for follow up share purchases, they will need to buy at a higher purchase price.

By the time you are fully invested, you may have missed out on higher returns than if you had been fully invested from the outset. There is always the trade-off between risk control and higher costs.

Another consideration is that the market could turn with indiscriminate sell-offs the order of the day. If the share price of a stock drops, those additional shares bought prior to the price collapse could wipe out any potential profits from previous trades.

The share price of well-established names do not always rebound if the fundamentals are bad. Credit: kurhan / Shutterstock

It is all about timing

The big decision for every trader is when to average up.

For instance, it could be when the share price has risen by a specific percentage above the initial purchase price – a trigger point. Depending on your trading timeframe, this could be, say, 2% or 10% or 25%.

Alternatively, investors may adhere to specific chart systems, either for individual shares or assets, or cumulative market-based charts, such as those identifying the number of stocks making new highs on a specific index or on a specific exchange.

Whatever the methodology, it is important that the confidence in an asset’s upward trend or growth prospects are well founded and based on good fundamental or technical analysis.

Sentiment should not come into it, investors averaging up need to stress test their decision-making process ensuring it is rational with no psychological bias, such as a hot hand fallacy. 

There is often a fixation in watching the ‘escaping winner’. Arguably, averaging up allows your brain to rule your heart. The appeal to some investors is that it provides a degree of risk control.

Good fundamentals

It may be that the market has under-valued a stock and that the fundamentals of the business such as its balance sheet, order book and management team are either in good shape or showing signs of improvement.

It is important that you do your own research if you are thinking of trading more shares. What signals are there that the fall in price is temporary or an undervaluation, rather than an indication of a deep-seated problem within the business?

As with averaging up, the focus should be on making rational decisions based on research, the market situation and according to a trading plan. Decisions should not be influenced by psychology and trading biases. You haven’t got a hot hand. You never have had.

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BNTX
BioNtech SE (Extended Hours)
114.46 USD

1.03 +0.910%

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