The hot hand and gambler’s fallacy: Throwing logic out the window
Overconfidence and gut feelings can lead to the hot hand and gambler’s fallacy in trading.
Seeing correlations that aren’t there or expecting a reversal in fortune because you think one is due can lead to unnecessary financial losses. Investors need to understand that they cannot control random outcomes.
What is the hot hand fallacy?
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 this idea might be appealing, 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 2006 paper by academics Rachel Croson and James Sundali refers to the “illusion of control”. This means that people wrongly believe that they can control outcomes that are random.
When applied to stock market investments, an investor or trader with a hot hand fallacy would expect to be rewarded for a new investment decision based on the fact that their previous investments had been profitable, despite this clearly not being the case.
Upping the stakes
Those who believe in the hot hand fallacy will often increase their stakes after a series of wins, reflecting the overconfidence they have in their own decision making.
The hot hand fallacy is common among 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 lead to errors or cognitive bias – giving credibility to illogical presumptions relating to other people.
An example is an investor buying or selling a fund principally on the portfolio manager’s track record, even though data points to this evidence being highly overvalued. The investor is basing their decision on whether they feel the fund manager is ‘hot’ or not.
This fits in with the ‘star manager’ concept that was prevalent in the mid-noughties, when fund providers marketed their products on the back of hyped investment gurus.
A significant number of these gurus have since faded into obscurity as their prowess for picking winners ran out of steam under volatile stock market conditions.
Feeling like luck is on your side? Photo: Gorodenkoff / ShutterstockWhat is the gambler’s fallacy
The gambler’s fallacy is the anticipation of a reversal following a sequence of one outcome.
Put simply, it means you do not accept that each roll of the dice is statistically independent from previous rolls. The assumption is made that purely because you have rolled, say, seven odd numbers in a row, the next roll is more likely to be an even number.
The tendency is to think: ‘I must be due an even number.’ This is not the case, as the results of previous rolls do not influence what you will get on the next roll. Each roll of the dice will deliver a random number from one to six.
Are you due a win?
The gambler’s fallacy bears resemblance to the hot hand fallacy. 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 investments, 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.
Consider an investor who decides to sell their position in a stock after it has risen in a series of trading sessions. They believe the stock is unlikely to continue its upward trajectory, as the chances of it making profit become lower as time proceeds.
No additional factors such as other valuations within that sector or broader economic indicators are taken into account. The investor simply presumes the stock must be due a fall.
Selling winning stocks too early is frequently identified as an example 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 assumptions.
FAQs
What are the hot hand fallacy and the gambler’s fallacy?
The hot hand fallacy is the belief that a successful streak will likely lead to further success, even when the odds are random.
A gambler’s fallacy is the belief that an event that has occurred often recently is less likely to occur again in the near future, instead of each event being statistically independent.
How do you avoid the hot hand fallacy?
Traders should understand that their hand is never hot. Each trade is independent. If we again examine the coin toss example, just because you threw tails three times in a row and won, it doesn’t guarantee the fourth toss will also result in a win.
How do you avoid the gambler’s fallacy?
It could be helpful to pay close attention to price rises and falls to locate an overall trend. Make your trading decisions based on logic, independent research and basic technical analysis.
