Hot Hand Fallacy

What is Hot Hand Fallacy?

The concept of the Hot Hand Fallacy is made up of two key terms: "Hot Hand" and "Fallacy". The term "Hot Hand" describes the belief that an individual who has experienced a series of successes is more likely to continue being successful in the future. On the other hand, "Fallacy" refers to a mistaken belief. Therefore, the Hot Hand Fallacy is the erroneous belief that an individual's past success guarantees continued success in the future based on a streak of consecutive wins.

Imagine this: you're flipping a coin with a friend. They predict that tails will come up three times in a row, and guess what? They're right! That's what we call having a "hot hand." It's like having a lucky streak when it comes to predicting outcomes. On the flip side (pun intended), if you keep getting it wrong and can't seem to predict the outcome, that's a "cold hand." Some people debate whether the hot hand is a real thing or just in our heads. Some studies say it's all in our minds, while others argue that it's a real phenomenon, especially in sports. So next time you're flipping a coin or watching a game, pay attention to those hot hands and cold hands. Who knows, maybe you'll start noticing some patterns yourself!

Psychologists posit that the hot hand fallacy stems from the use of heuristic techniques. Heuristic techniques, a well-known concept in behavioral economics, involve problem-solving methods that prioritize finding quick solutions over optimal ones within a given timeframe. This risky heuristic approach can significantly influence consumer decision-making.

For example, if someone makes money from a certain stock, they might keep buying that stock without considering its prospects. They could have seen positive results for a short time, like a week or a month, but that doesn't mean it will continue for longer, like 6 months or a year. Maybe they didn't do enough research before investing. Just because a stock did well in the past doesn't guarantee it will do well in the future. These mistakes can make someone's investment strategy more like a guessing game.

The short-term positive earnings trend of stocks may not accurately reflect the overall trajectory of stocks shortly. To avoid relying on a heuristic approach, investors should thoroughly analyze the past track records of stocks and conduct a comprehensive analysis before making investment decisions. By selecting stocks with strong fundamentals that are likely to yield long-term profits, investors can mitigate risks associated with depending solely on short-term indicators and performance. It is essential to prioritize a strategic and informed approach to investing to maximize returns and minimize potential losses.

How Hot Hand Fallacy Really Works?

The Hot Hand Fallacy is something you can spot in areas like investing and sports. It's when people think someone is on a winning streak or a losing streak based on their past performance. If someone has been doing well lately, they're seen as having a "hot hand." But if they've been slacking or not meeting expectations, they're seen as having a "cold hand." It all comes down to how each person sees it. But here's the thing - just because someone did great in the past doesn't mean they'll keep it up in the future. For example, flipping a coin doesn't care how you flipped it before, same goes for rolling a die. So, don't get too caught up in thinking someone's luck will always be the same!

When considering the purchase of a mutual fund, many individuals are naturally drawn to selecting a fund manager with a proven track record of success. It is common for investors to prefer a fund manager with experience in the field of fund management, rather than a newcomer. This tendency reflects a preference for "hot" fund managers - those who have demonstrated their ability to achieve positive results in the past. This same principle can be observed in sporting events. Players often gravitate towards teammates who have recently performed well and contributed significantly to the team's success. This preference leads to a pattern of passing the ball to the player who is "hot" in the game, meaning they have recently scored back-to-back points and are more likely to score again in the future.

Some Theories Incorporating Hot Hand Fallacy

1. Hot Hand in Basketball

First described by Thomas Gilovich, Amos Tversky, and Robert Vallone in a 1985 paper entitled "Hot Hand in Basketball," the concept raised the question of whether basketball players truly experience a hot hand phenomenon. The term "hot hand" is defined as the belief that players are more likely to make a successful shot if their previous shots were successful. This paper delves into the intricacies of this theory and its implications for the game of basketball.

The researchers set out to determine if the hot hand phenomenon is real by conducting a study in four phases. First, they surveyed 100 basketball fans from Stanford and Cornell colleges. Next, they analyzed player records from the 1980-81 NBA season. Then, they looked at free throw data, and finally, they conducted a controlled shooting experiment. By conducting these varied studies, the researchers were able to gradually eliminate external factors that could impact a basketball shot, leading to a more refined experiment.

The study revealed that events were independent of each other, whether it was a controlled shooting experiment or a free throw. The perception of an individual towards someone being "hot" does not predict the success or failure of the player's next performance.

2. Confirmation bias and Clustering Illusion

Gilovich proposed two explanations for why people believe in the hot hand phenomenon: confirmation bias and clustering illusion. Confirmation bias means that someone might focus on a player's streaks before actually watching a basketball game, which can affect how they perceive the player's performance. On the other hand, the clustering illusion refers to our tendency to underestimate the amount of variability that can occur in a small sample of random data. This means that we may not be able to recognize when a player is just getting lucky with their shots. So basically, according to the clustering illusion, we might not realize when a player is just having a lucky streak on the court.

3. Reanalysis of GTV (Gilovich, Tversky, and Vallone Study)

In 2018, Miller and Sanjurjo published a refined version of the Generalized Trust Violation (GTV) study. Their findings presented a contrasting result to the original GTV study, leading them to conclude that there is substantial evidence of streak shooting.

GTV assumed that a hot hand exists if the likelihood of a hit is greater after a series of hits than after a series of misses. However, Miller and Sanjurjo disagreed with this assumption, pointing out a flaw in it. They argued that the rate of hits after a series of hits is actually lower than the rate of hits after a series of misses. This led them to conclude that there is an equal rate of hits and misses after a streak, which indicates a hot hand in the game.

The researchers contended that GTV in their study was influenced by sampling bias, as they began counting after a series of hits or misses. They demonstrated analytically that a series of one-hit indicates a bias towards more misses, especially when the sample size is small. Therefore, it would be unrealistic to anticipate a consistent 50% accuracy from a shooter who has taken approximately 100 shots, even after scoring three streaks in a row.

4. 2003 Study by Koehler, J.J. & Conley C.A.

This study was conducted to investigate the phenomenon of the "hot hand" in professional basketball players. Researchers analyzed NBA shooting data from 1994 to 1997. According to the findings, a player with a hot hand tends to have streaks of successful shots and misses grouped together. The researchers also compared the shooting patterns of players during hot streaks versus cold streaks.

According to their analysis, there was no evidence to support the hot-hand fallacy. This suggests that an individual's belief in the hot-hand fallacy may influence a player's perception of success.

How Hot Hand Fallacy Impacts Investment Decision Making?

The Hot Hand Fallacy is a common mistake people make when buying and selling in the financial market. It often happens when investors choose professional fund managers to handle their money. It's natural for investors to do some research before investing, right? So, when they come across a fund manager with a great track record of managing funds and delivering high returns to investors, they're likely to pick that fund. They hope to see the same exceptional returns in the future based on the manager's past performance.

It is a well-known fact that regardless of the fund manager's reputation, inconsistencies in performance are inevitable. It is important to acknowledge that not every fund manager will consistently provide the best returns on investment. This phenomenon is often attributed to the hot hand fallacy, which can lead to biased decision-making. Individuals who fall victim to the hot hand fallacy believe that a fund manager is on a winning streak and invests their capital without considering the potential risks. It is crucial to understand that past success does not guarantee future profitability when it comes to managing funds. Therefore, investors need to exercise caution and conduct thorough research before entrusting their capital to a fund manager.

The illusion of control is when people believe they have complete control over random events. This belief can have a big impact and lead to the hot hand fallacy in investing. Basically, this means that investors start to think they're invincible. They might buy more shares when they're making money, and then sell off shares when they're losing money. But they're not really thinking about the long-term value of their assets.

Significance of Hot Hand Fallacy

It is crucial to understand the concept of the hot hand fallacy as it often leads us astray from making sound investment decisions based on logic and rationality. This fallacy can cause us to make subpar decisions, misinterpret patterns and trends, and base our decisions solely on them. It is important to be mindful of this cognitive bias to make informed and strategic investment choices.

The hot hand fallacy is something we all experience in our daily lives. It's when we think that because we've been lucky in the past, we'll continue to be lucky in the future. For example, if we win the lottery one week, we might pick the same numbers the next week, thinking they're lucky. But in reality, past luck doesn't affect future outcomes - each event is independent. This same idea applies to investing and sports too. Just because we've been on a winning streak doesn't mean it will continue. It's important to remember that luck is just luck, and we can't rely on it to predict the future.

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

The concepts of the Hot Hand Fallacy and Gambler's Fallacy are opposed in their implications. The Hot Hand Fallacy suggests that individuals believe their past successes increase their likelihood of future success. Conversely, the Gambler's Fallacy posits that an event is less likely to occur in the future if it has happened more frequently than expected in the past. These two fallacies represent contrasting beliefs about the relationship between past and future outcomes.

Some people think that if they've been winning, they'll keep winning because luck is on their side. Others believe that if they've been winning, their luck will run out soon because they can't keep winning forever. This is known as the gambler's fallacy, where people think that past outcomes will affect future ones.

Both the hot hand fallacy and the gambler's fallacy are behavioral biases that individuals often exhibit during decision-making processes, whether it be in investments, sports, or everyday tasks.

Conclusion

In conclusion, individuals need to have a solid understanding of the hot hand fallacy, as it often plays a role in our everyday decision-making processes. This phenomenon becomes particularly crucial in the realm of investing, where avoiding the hot hand fallacy can lead to more informed and successful investment decisions, free from the influence of external behavioral biases.

Numerous researchers have presented arguments both in support of and against the hot hand fallacy. As investors, it is imperative to thoroughly examine the research conducted by these experts before forming our own opinions on the matter. By doing so, we can determine which strategies are most effective for our individual investment goals.

By recognizing and avoiding the hot hand fallacy, we can make significant improvements to our decision-making behaviors. However, it is crucial to thoroughly study the implications of this fallacy to fully understand its impact on our investment decisions.