We always try to see some patterns in randomness. This is why it's so easy for a trader to believe that his hand is “hot” аnd he can't lose abruptly after a series of winning trades. Well, this is not true. Let's explain why.
What is a hot hand fallacy?
Originating from America, the term ‘hot hand’ refers to a basketball player’s higher chances of hitting a basket after a hit, rather than a miss. If he continues to make baskets, it can be said that he has a ‘hot hand’.
Hot hand bias in trading occurs when a trader starts to believe he or she is on a winning streak, their hand is ‘hot’ so they can’t lose. Unlike basketball, the markets depend on a variety of external circumstances, not a person’s individual skill.
Similar to the gambler’s fallacy, the trader fails to recognise trades as independent, preferring to believe that the ‘winning streak’ will continue.
Who was the first to describe the hot hand fallacy?
The hot hand fallacy originated in 1985, when famous behavioral scientists Thomas Gilovich, Robert Vallone and Amos Tversky, also referred to as GVT, published their “Hot Hand in Basketball” research.
The study was aimed to prove that people are wrong in making assumption that players have “hot hands” and have more chances for another successful shot after a series of hits. The scientists claimed that people misinterpret randomness and make incorrect conclusions. Like in the “coin toss”, people believe that the probability of heads or tails increases after a sequence of either has happened. In their study, supported by numerous experiments and statistical data, GVT concluded that the sense of being “hot” can’t predict or guarantee future hits or misses.
However, the newer studies, including the one by Joshua Miller and Adam Sanjurjo, found some evidence that the hot hand may work for real in certain sporting events.
Hot hand fallacy in trading and investing
When trading, those under the influence of the ‘hot hand’ fallacy expect to be rewarded for trading decisions purely on the basis that their previous trades were successful. They believe their chances to profit are higher. The more trades a trader has in his ‘winning streak’, the less likely he is to believe he will lose.
But, this is not the case, the streak has to end somewhere and if the trader fails to take account of his or her confidence biases, they risk losing their capital in the trade.
If the investor starts thinking of positive outcomes, as a result of a hot hand phenomenon, it can bring up some other trading biases as well, including: confirmation bias (when investor believes only the information which proves his point) and the illusion of control (when people have an illusory view of their wealth).
Some believe that the hot hand fallacy is derived from a gambler’s fallacy and serves as its direct contradiction. If the gambler’s fallacy presupposes a strong belief in systematic reversals, the hot hand bias stands for excessive persistence. This could result in one of the easiest trading mistakes – to think that your past trades may affect the future ones.
It is claimed that traders and investors, affected by the hot hand bias misinterpret random sequences. Hot-handed traders tend to misidentify a non-correlated sequences – a series of winning trades – as autocorrelated. It generates a faulty belief that a certain pattern will continue working in the future.
In financial markets, the hot hand bias is also observed when traders try to delegate their investment decisions to professional fund managers, who have a successful background, believing they will be able to persistently continue the high performance track record.
How to avoid the hot hand fallacy?
Realise that when trading your hand is never hot, even if you’ve made a series of successful trades in a row. Each trade is independent. If we again examine the coin toss example, just because you threw tails three times and won, it doesn’t mean the fourth toss will also result in a win.
Not every trade will be a winner, no matter how well you’ve traded in the past. Analyse each and every trade, don’t make rash decisions and come to logical conclusions for your trading choices.