DP6081 The Gambler's and Hot-Hand Fallacies: Theory and Applications

Author(s): Matthew Rabin, Dimitri Vayanos
Publication Date: February 2007
Keyword(s): behavioural finance, gambler's fallacy, hot-hand fallacy
JEL(s): D8, G1
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6081

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 \textit{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.