What Is Hot-hand Fallacy And How To Avoid It
Heuristics are a way for us humans to make decisions quicker, but sometimes relying on them leads to poor ones. Hot-hand fallacy is a heuristic that can cause bad financial decisions, but what is it and is there a way to avoid it?
What is hot-hand fallacy
Hot-hand fallacy was first researched in the 1980s and gets its name from the basketball phenomenon “hot hands”, where a player is on a streak of scoring.
Hot-hand fallacy is the belief that recent good fortune is going to continue, for example a basketball player who has made two shots already is more likely to make a third.
It is believed to happen because people tend to want to see patterns in the short term and using small samples to make decisions. For example making bets based on a players performance in the game so far rather than considering their statistical performance over a long period of time.
According to a study the older you are the more susceptible you are to hot-hand fallacy as the older you are the more likely you are to rely on heuristics when making decisions.
This heuristic may sound similar to gambler’s fallacy, but is has the opposite effect, because in gambler’s fallacy you believe your luck will change, where as hot-hand fallacy tells you your current streak will continue.
How to avoid it
Heuristics can be hard to avoid, we use them usually without thinking, which is their whole point.
One way to avoid this specific one is to remind yourself of the full statistics rather than just a small sample size.
For example when it comes sports bets, rather than considering a team’s or a player’s recent success, you should look at their performance long term to make more accurate and reasonable predictions.
Also, remembering that we are more likely to fall for this fallacy as we age, so the reasons for any decisions we make should be carefully considered.
Hot-hand fallacy and personal finance
Hot-hand fallacy is often considered when it comes to sporting context, such as sports bets, but it does have relevance in personal finance as well.
We might see a company share experience a sudden rise for a few days and due to this fallacy think that it will continue and buy in. Only to realise then that it was nothing but a blip and the share price went back down.
It is often best to make investment decisions based on more long term reasons, rather than invest out of FOMO (fear of missing out).
You can read more here and find my other posts about heuristics and biases here.
Have you ever fallen for hot-hand fallacy?
