What is the Hot Hand?
The 'hot hand' is the notion that because one has had a string of successes, an individual or entity is more likely to have continued success. For example, if one flipped a (fair) coin and guessed correctly that it would land on heads three times in a row, it might be said that they have a "hot hand." Under such circumstances, a person believes that their odds of guessing which side the coin will land on next are greater than the 50% they actually are. When there is a series of failures, the same concept works as the 'cold hand'.
While the hot hand feels like it happens all the time, academic research has shown this phenomenon to by purely psychological. Newer studies, however, do show some support for the hot hand in certain sporting events.
How the Hot Hand Works
The belief in a hot hand is one shared by many gamblers and investors alike and is believed by psychologists to stem from the same source, the representative heuristic. For example, there is data to suggest that the decision of an investor to buy or sell a mutual fund depends largely on the track record of the fund manager, even though there is evidence that this factor is highly overrated. Hence, it would appear that such investors are making decisions based on whether or not they feel the fund managers are "hot" or not.
The hot hand fallacy is the psychological condition that people believe an individual is "hot" or "cold" depending on past performance, when that performance has no bearing on future outcomes. For instance, rolling a die is independent of how you rolled in in the past.
- The 'hot hand' is the notion where people believe that after a string of successes (or failures), an individual or entity is more likely to have continued success (or failure).
- Psychologists believe that the hot hand is a fallacy that stems from the representative heuristic, as identified by behavioral economics.
- Still, some research shows that for certain sporting events, the hot hand may be real.
Evidence For and Against the Hot Hand
When gambling, as in investing, it is not uncommon to experience a good streak partly driven by momentum. However, the idea of favorable outcomes are a result of a hot hand is purely a phenomenon. In reality, once an investor, and likely a gambler, begins to think they have a hot hand, many proven biases can arise. Several common behavioral gaps, which can be brought on by a hot hand include overconfidence, confirmation bias, illusion of control, recency bias and hindsight bias — just to name a few from the growing list of the popular market psychology factors.
New research using modern statistical analysis offers a bit of evidence for the "hot hand" in certain sporting events. The Supreme Court's May 2018 decision to ease federal laws prohibiting commercial sports betting in most states, opens the door to legalizing the estimated $150 billion in illegal wagers on professional and amateur sports in the U.S. every year. As sports betting becomes more mainstream, it's not unthinkable that investment strategies explicitly following a hot hand will pop up.