Tuesday, August 16, 2005

The Gambler's Fallacy and the Hot Hand: Empirical Data from Casinos

The Gambler's Fallacy and the Hot Hand: Empirical Data from Casinos
Moneyscience.org points to the paper by Croson and Sundali (in the Journal of Risk and Uncertainty) who use video from a casino to document the existence of both a gambler's fallacy (the idea is that because some event has not happened in a while it is "due" and the hot hands fallacy (I am on a roll, so I will remain lucky).

A few "look-ins":
  • "The gambler'’s fallacy is a belief in negative autocorrelation of a non-autocorrelated random sequence."
  • "In contrast, the hot hand is a belief in positive autocorrelation of a non-autocorrelated random sequence"
  • "someone can believe both in the gambler'’s fallacy (that after three coin flips of heads tails is due) and the hot hand (that after three correct guesses they will be more likely to correctly guess the next outcome of the coin toss). These biases are believed by psychologists to stem from the same source, (the representative heuristic) as discussed below and formalized in Rabin (2002) and Mullainathan (2002)."
So what are the implications to the finance world? In the authors' words:
"it has been argued that the disposition effect in finance (the tendency of investors to sell stocks that have appreciated and hold stocks that have lost value) is caused by gambler'’s fallacy beliefs....Other evidence demonstrates that consumers'’ mutual fund purchases depend strongly on past performance of particular fund managers (Sirri and Tufano, 1998), even though the data suggest that performance of mutual fund managers is serially uncorrelated (e.g. Cahart, 1997). Thus, individuals are presumably making investment decisions based upon the belief that particular funds or fund managers are "“hot." ”"
So what does this mean to the average investor? That (s)he should be aware of the fallacies and be careful to avoid falling into their traps. The best way to do this is to remain rational about investing, which of course is easier said than done. ;)

Cite for paper:
Rachel Croson, James Sundali, The Gambler'’s Fallacy and the Hot Hand: Empirical Data from Casinos, Journal of Risk and Uncertainty, Volume 30, Issue 3, May 2005, Pages 195 - 209

Thanks again to MoneyScience for pointing this article out!

As antecdotal evidence of these fallacies I often use my own experience at my family's small chain of grocery stores. It is amazing to see certain customers (and a few employees) continually put money into the instant lottery machine as they say "I have put in $20 without a winner, the next one has to be a winner." Alternatively I have seen people give money to another person to put it in saying "you are always luckier than I am at this." Uh, ok...

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