By: Rupesh Oli
What is Hot Hand Fallacy?
Hot Hand Fallacy comprises two terminologies ‘Hot Hand’ and ‘Fallacy’, whereby Hot Hand refers to a belief an individual possesses when s/he had a back-to-back string of successes, is likely to have continued success further; and Fallacy simply refers to the mistaken belief. Hence, Hot Hand Fallacy as a whole means the mistaken belief that an individual possesses in terms of continuity to their successful track based on their past performance of achieving a back-to-back winning outcome.
For instance, if an individual tossed a coin, and the other one predicted that tails would occur three times in a row, then the one who correctly predicted the outcome is said to have a hot hand. In such a scenario, a belief by a person to successfully predict the side of a coin as an outcome, may it be heads or tails, will be higher than 50% than the actual possible outcome.
On the contrary, if an individual fails to deliver the outcome (or predict the successful outcome) for a longer streak, it is referred to as cold hand. There exist mixed perceptions regarding whether hot hand actually exist or not. Some academic research argues that the hot hand is purely a psychological phenomenon, whereas several newer studies do argue that the hot hand exists when it comes to sporting events.
Psychologists believe that the hot hand fallacy originates from the heuristic technique. Heuristic technique, well-known terminology in behavioral economics, refers to a problem-solving approach, where one tries to find out the shortcuts to solve the problems, which are sufficient for a given deadline that may or may not be optimal at all. Such a dangerous heuristic can greatly impact consumer decision-making.
For instance, when an individual sets a positive earning track record from a particular stock, s/he tends to buy the same stock on coming days as well, no matter what sort of future prospect it reflects. The user might have experienced a positive trend for a shorter time frame, maybe a week or month. However, it does not reflect the scenario for a longer period like 6 months or 1 year. Maybe the user had invested in the stock without proper technical and fundamental analysis. There is no surety that the particular stock chosen by an individual is likely to provide positive earning in the future as well, as it did in the past. Thus, all these sorts of flaws make the path that an individual has chosen, a heuristic scenario.
The short-term positive earnings trend of stocks does not reflect the overall trend of stocks in the coming days. Instead, what the user should have done to avoid heuristic approach is: s/he must have properly studied the past track records of stocks and try to come up with an optimal analysis before investing in the stocks so that s/he could have selected the stocks with strong fundamentals which is likely to profit him/her for the long run, rather than just depending on few indicators and short-term performance of the stocks.
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How Hot Hand Fallacy Really Works?
Hot Hand Fallacy can be seen in sectors such as investment and sports. It occurs when people tend to believe an individual is hot or cold depending on his/her past track records. If an individual has an exceptional track record recently, s/he is believed to have a hot hand. On the other hand, s/he is believed to have a cold hand, if not able to perform up to the mark or had shown below-average performance recently. It all boils down to the perception of an individual how s/he perceives it. It is also a fact that the performance shown in the past may not have a significant impact on the future outcome. For instance, tossing a coin is independent of how you tossed the coin previously or the same goes for the event like rolling a die.
When it comes to buying a mutual fund, it is obvious that most of us are inclined towards the selection of a fund manager based on his/her past track record. We might not simply select the fund manager who does not have prior experience in the field of fund management or someone newbie. From this example, it can be seen that we are actually opting for fund managers based on whether they are actually hot or not. The same goes for sporting events as well. The players tend to favor the one who has scored back-to-back and was able to generate enough points for the team recently; it ultimately leads other players to pass the ball to one who is hot in the game, implying s/he recently scored back-to-back in the game denoting the higher probability to score in the next shot.
Some Theories Incorporating Hot Hand Fallacy
1. Hot Hand in Basketball
First described by Thomas Gilovich, Amos Tversky, and Robert Vallone in 1955 paper entitled ‘Hot Hand in Basketball’, raised a question of whether basketball players really have a hot hand or not. The term hot hand is defined as ‘players are more likely to have a successful shot if their previous shots were successful’, in respect to this particular paper.
The main aim of the researchers was to find out whether hot hand really exists or not for which the study was conducted in four phases. The first study was via a questionnaire distributed to 100 basketball fans from Stanford and Cornell college; the second study analyzed individual records of the players from 1980-81 NBA season; the third one analyzed free basketball throw data and the fourth studied controlled shooting experiment. The reason for varied studies was to gradually eliminate the external factor impacting the basketball shot which ultimately led to further refinement for the experiment.
What the study found out is; the events were independent of each other, whether it be a controlled shooting experiment or free throw; the perception of an individual towards someone being hot does not predict the hit or misses, the player is going to perform next.
2. Confirmation bias and Clustering Illusion
Gilovich offered two different explanations to figure out why people think hot hand exists on the basis of confirmation bias and clustering illusion. Confirmation bias, implying an individual might be biased towards looking at the streaks of a player before actually watching a basketball game, impacting his/her perception. Clustering illusion on other hand refers to the human tendency to not be able to predict the amount of variability that is likely to appear in a small sample of random data. Hence, as per clustering illusion, an individual is not able to recognize chance sequences (a player’s chance of hitting the basketball net).
3. Reanalysis of GTV (Gilovich, Tversky, and Vallone Study)
Miller and Sanjurjo published the refined work of GTV in 2018, in which they came up with the contrary result if compared to GTV and concluded that “There is significant evidence of streak shooting”.
GTV made the assumption that there is a confirmation of hot hand if the probability of a hit is higher after a streak of hits than the probability of hits after a streak of misses. However, Miller and Sanjurjo argued this assumption has a flaw and is not correct. Instead, they justified that the expected rate of hits after a streak of hits is actually lower than the rate of hits after a streak of misses, concluding that there is an equal rate of hits to misses after a streak, in a game which is a sign of hot hand.
They further argued that GTV reflected sampling bias in their study as they started counting after a series of hits or misses. They analytically showcased that a series of one-hit indicates a bias towards more misses, given the sample size is small enough. Hence, it would be impractical to expect a consistent 50% from a shooter who has taken about 100 shots to score half of the shots immediately after they score three streaks in a row.
4. 2003 Study by Koehler, J.J. & Conley C.A.
This study was conducted with the prime motto to study the hot hand in professional basketball players. Researchers examined the NBA shooting contests from the year 1994 to 1997. As per the research, a player with a hot hand must have very few runs, and their hits and misses must be in clusters. Further, they compared the hits with the misses of the basketball shooters.
As per their analysis, there was nothing that supported the hot-hand fallacy, which implied that an individual’s belief in the hot-hand fallacy actually impacts a player’s perception of success.
How Hot Hand Fallacy Impacts Investment Decision Making?
Hot Hand Fallacy comes into play when it comes to buying and selling in the financial market. It is common among those who tend to select professional fund managers for managing their capital amount. It is obvious that investors will carry out some sort of research when it comes to investing. Once they find out that a particular fund manager has an exceptional track record of managing the funds over the years and was able to provide an exceptional return to the investors under his/her umbrella, it is for sure that an investor would tend to select that particular fund, in the hope of receiving an exceptional return in the coming days based on his/her record.
However, it is also a fact that no matter who the fund manager is, there are inconsistencies in his/her performance. It is also the fact that not always, the fund manager will be providing the best bang for the buck. So, it is the impact of the hot hand fallacy that leads towards the biased decision. Individuals with such a fallacy think that the fund manager is hot, and they invest all their capital without giving a single damn about the possible outcome of the capital they invested. It is to be noted there will be no assurance that a fund manager who had a successful track record in the past, is likely to be profitable managing the fund in the coming days as well.
Illusion of control, which refers to the belief of people that they exert full control over random events; possesses a significant impact leading to a hot hand fallacy in investing. Such illusion control leads an investor to think of themselves as supreme, due to which they increase the number of shares they invested in when booked profit; and decrease the number of shares, after some losses; without even considering the discounted future value of assets.
Significance of Hot Hand Fallacy
It is vital to be aware of the hot hand fallacy because it is the one leading us towards faulty investment decisions rather than logic and rationality. We tend to make a decision that is not up to the mark, misidentify the patterns and trends and make our decision solely based on them.
Hot Hand fallacy is something that can be experienced in our day-to-day behavior as well. If we got lucky enough on some events to get a back-to-back winning streak, we are sure to make a further decision based on the recent track record. For instance, suppose that we recently won the lottery ticket and if we want to buy a lottery ticket for the next time; we tend to pick the ticket based on last time’s winning ticket number. We tend to disregard the fact that neither our past luck nor winning number impacts the likelihood of winning the lottery next time as the events are independent of each other. The same concept can be applied when it comes to investing and sporting events.
How to Avoid Hot Hand Fallacy?
- Make sure your logical reasoning ability during decision-making is not overshadowed by the hot hand fallacy.
- Being aware of the trap of the hot hand fallacy can lead you to think multiple times before your investment decisions.
- Do not try to base your decision on a small set of data like back-to-back multiple winning streaks. Instead, try to see the larger picture by incorporating larger sets of data before you select a particular company to invest in.
- Let us take an example. If you tend to select a stock based on its previous week’s performance as it skyrocketed in the previous week, then you might be inclined towards the hot hand fallacy. Instead, have a look at larger statistics of that particular stock. For instance, EPS, P/E ratio, net profit in the last four quarters, dividend history, and so on.
Gambler’s Fallacy vs Hot Hand Fallacy
Hot Hand Fallacy and Gambler’s Fallacy are exactly opposite from one another in terms of what they are trying to convey. In hot hand fallacy, an individual believes that s/he has greater chances of acquiring success in the future based on their successful outcome in the past; whereas, in gambler’s fallacy, an individual believes that an event is less likely to occur in the future if it has occurred more frequently than normal in the past.
An individual believes the winning streak is more likely to continue; the luck will favor them when it comes to hot hand fallacy. On the contrary, individuals possess a strong belief that the luck will turn around and stop favoring them as repetition of the same outcome on a continued basis leads to the decline of the probability of occurrence of the same successful outcome in the future in what is believed by the individual in gambler’s fallacy.
Both hot hand fallacy and gambler’s fallacy refer to a behavioral bias that one tends to possess during decision making, be it an investment, sports, or normal daily tasks.
To conclude, everyone needs to have some sort of knowledge regarding the hot hand fallacy as it is something even reflected in our day-to-day decision-making. When it comes to investing, it becomes even more vital to take the hot hand fallacy into consideration so that one can perform better investments without the external behavioral bias influencing him/her. Various researchers have presented arguments both for and against the hot hand fallacy. As an investor, one needs to dig down to know the level of research that one has conducted before s/he agrees or disagrees with the implications the researchers have come up with. Once done, s/he can filter out what works best for them. If we know how to avoid the hot hand fallacy, then it can lead us to some sort of refinements in our decision-making behavior as well. Nevertheless, the significance of the hot hand fallacy is what needs to be properly studied to know the intensity of impact it creates on our investment decision.
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