Over-confidence and gut feelings are too often the stock market trader’s downfall and the 'hot hand' and 'gambler's falacy' are two of the ways they most often get caught out.
Seeing correlations that aren’t there or expecting a reversal in fortune just because you think one is due often lead to unnecessary financial losses.
Investors need to understand that they cannot control outcomes that are random.
The hot hand
The term hot hand, originates from US basketball. It centres on the belief that the chance of hitting a basket is greater following a hit than a miss.
While it might be an appealing thought, the reality is that there is no positive correlation between successive shots. Studies show the hot hand is a misperception of chance in random sequences.
A paper by academics Sundali and Croson (2006) refer to the ‘illusion of control’. This means that people wrongly believe that they can control outcomes that are random.
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 investments were profitable.
Upping the stakes
Those who believe in the hot hand will often increase their stakes after a series of wins, to reflect the over-confidence they have in their own decision making.
The hot hand theory is all too common amongst investors and is frequently associated with representative heuristics.
In layman’s terms, this is using shortcuts or rules of thumb rather than detailed analysis to make quick decisions. These mental short-cuts can frequently lead to errors or cognitive bias - that is illogical presumptions relating to other people being given too much credibility.
For example, an investor buying or selling a fund principally on the track record of the portfolio manager even though data points to this evidence being highly overvalued. Fundamentally investors are basing their decisions on whether they feel the fund managers are ‘hot’ or not.
Failing to pick winners
This fits in with the ‘star manager’ concept that was prevalent in the mid noughties when fund providers heavily marketed their products on the back of much-hyped investment gurus.
A significant number of these so-called gurus have since faded into obscurity as their prowess for picking winners ran out of steam under severe stock market conditions.
The Gambler’s Fallacy
The gambler's fallacy is the anticipation of a reversal following a sequence of one outcome.
In simple terms, it means you do not accept that each roll of a die is statistically independent from previous rolls. The assumption is made that purely because you have rolled, say, 7 odd numbers, the next roll is more likely to be an even number.
The tendency is to presume: “I must be due an even number”. This is not in fact the case as the results of previous rolls do not influence what you will get on the next roll. Each roll of the die will deliver a random number from 1 to 6.
Are you feeling lucky?
The gambler’s fallacy bears resemblance to the hot hand. However, the gambler’s fallacy concerns the outcomes of a random process (like the throw of dice) while the hot hand is about the outcome related to an individual’s performance (like winning or losing).
In relation to stock market investment, the gambler’s fallacy would be in evidence if investment decisions were based on a wrongly assumed probability of a trend either ending or continuing.
As a practical example, consider an investor who decides to sell their position in a stock after it has risen in a series of trading sessions. They believe that the stock is unlikely to continue its upward trajectory as the chances of it making profit become lower as time proceeds.
Selling too early
No additional factors, such as other valuations within that sector or broader economic indicators, are taken in to account. The investor just presumes that the stock must be due a fall so bails out. Selling winning stocks too early are frequently identified as examples of the gambler’s fallacy in action.
To counter the gambler’s fallacy, investors need to ensure their decisions are rational and based on hard evidence rather than nebulous assumption.