The Gambler's and Hot-Hand Fallacies
Interesting new academic paper called "The Gambler's and Hot-Hand Fallacies: Theory and Applications" has just been published.
Gamblers are a fickle bunch often believing in lady luck. The best professional poker players are, however, ruthlessly mathematical and logical.
This interesting (but technical) paper explains the problem.
The Gambler's and Hot-Hand Fallacies: Theory and Applications
MATTHEW RABIN
University of California, Berkeley - Department of Economics
DIMITRI VAYANOS
London School of Economics; Center for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER) February 2007
CEPR Discussion Paper No. 6081
Abstract:
We develop a model of the gambler's fallacy - the mistaken belief that random sequences should exhibit systematic reversals. We show that an individual who holds this belief and observes a sequence of signals can exaggerate the magnitude of changes in an underlying state but underestimate their duration. When the state is constant, and so signals are i.i.d., the individual can predict that long streaks of similar signals will continue - a hot-hand fallacy. When signals are serially correlated, the individual typically under-reacts to short streaks, over-reacts to longer ones, and under-reacts to very long ones. We explore several applications, showing, for example, that investors may move assets too much in and out of mutual funds, and exaggerate the value of financial information and expertise.
Keywords: Behavioural finance, gambler's fallacy, hot-hand fallacy
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