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.