Hot Hand

Updated on April 4, 2024
Article byPrakhar Gajendrakar
Edited byPrakhar Gajendrakar
Reviewed byDheeraj Vaidya, CFA, FRM

What is Hot Hand?

Hot hand refers to the belief that a continuous series of a positive results will continue to thrive. For example, people often believe that if a company or its share has performed well in the past, it will continue the same trend in the future.

The concept advocates the subsistence of positive outcomes, whereas the phrase cold hand coined the continuity of negative results. Both ideas reflect the impression of past trends to be continued in the future. This interesting psychological phenomenon is mainly observed in sports and financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more.

Key Takeaways

  • Hot hand fallacy in psychology is a notion and belief that a series of successful outcomes in the past of any entity, individual, or investment will continue likewise in the future.
  • Academics defines it as a behavioral bias.
  • The opposite concept is the cold hand, where the horrible history or loss endured by an entity is predicted to continue.
  • Apart from sports and gambling, this phenomenon plays a prominent role in investment decisions. Investors buy stocks that have shown good returns and healthy past performance

Hot Hand Fallacy Explained

The hot hand fallacy was first explained in the cognitive psychology article “The Hot Hand in Basketball: On the Misperception of Random Sequences” by Thomas Gilovich, Robert Vallone, and Amos Tversky. The article focused on the origin and validity of the hot hand and streak shooting in basketball. People believe that a player’s chance of hitting a shot is greater if the previous shot is a hit. However, empirical evidenceEmpirical EvidenceEmpirical evidence refers to factual data that is collected by conducting observations and experiments. It is a systematic process; every step is documented. Further, raw data is used to derive meaningful conclusions and findings.read more shows no positive correlationPositive CorrelationPositive Correlation occurs when two variables display mirror movements, fluctuating in the same direction, and are positively related. In layman's terms, if one variable increases by 10%, the other variable grows by 10% as well, and vice versa.read more between the results of successive shots.

Hot Hand

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Researchers match this concept with behavioral biases like extrapolation or recency biasRecency BiasRecency bias is a type of cognitive bias where people make conclusions based on recent events.read more. People predict the random outcomes of an event by studying their past performance, which may or may not come out as true. If it comes out true, they will continue to believe in the concept. Continuous experience plays an important role in programming their brain to use the same concept whenever a similar situation arises. 

It is increasingly investigated in disciplines including psychology and behavioral economicsBehavioral EconomicsBehavioural economics refers to a stream of mainstream economics that studies the impact of human psychology, ideology or behaviour on the individual or institutional economic decision-making process.read more in conjunction with another opposing concept known as the Gambler’s Fallacy, sometimes known as the Monte Carlo Fallacy. It illustrates how a sequence of something will be followed by the occurrence of its inverse, that is, exhibiting negative recency. Both notions represent the process by which the human brain seeks to make sense of the occurrence of random sequential events.

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Video Explanation of Hot Hand

 

Example

Let us consider the example of Amplify Energy Corp., signifying one of the classic hot hand fallacy examples.  

The company’s stock price declined almost 50%, reporting a significant oil spill off the Orange County Coast on October 2, 2021. Approximately 12600 gallons of spill occurred between Newport Beach and Huntington Beach spreading over 6 miles. Its impact is drastically reflected on the Amplify Energy stock price.

The stock price was making a bullish run, specifically from the last week of September 2021, signifying the influence of the hot-hand effect on investors. Many investors believe in the sustainability of upward trends refraining from rationality. But the oil spill news came at a very inopportune time. It has tremendously affected its stock price, it plunged to 2.8800 on October 4 from the previous level of 5.3700, and it never rebounded to the previous highest level. Hence confirming a fallacy about stock price movement.

Role of Hot Hand in Investing

The future performance of investments is highly uncertain. This uncertainty prompts many investors to follow heuristicsHeuristicsHeuristics refers to a problem-solving and decision-making approach where individuals or entities consider past results or experiences and the minimal relevant details to reach a practical conclusion.read more and biases, giving less importance to rational thinking to derive easy solutions to complex problems. All these point to the fact that the human brain is programmed to recognize patterns based on stock price movements. Ultimately investors fall for a fallacy.

The fallacy is still very much present in investing. Even professional investors believe in this phenomenon. For example, investors affected by Gambler’s Fallacy sell their stocks when the prices are at their peak, and if affected by the hot-hand effect, they buy stocks when prices are rising. Investors following the fund managers with good past performance is another event signifying the irrational choices.

People derive benefits and disadvantages from hoping the series of wins will sustain the two sides of the same coin. It is evident if we analyze the case of people jumping into the cryptocurrencyCryptocurrencyCryptocurrency refers to a technology that acts as a medium for facilitating the conduct of different financial transactions which are safe and secure. It is one of the tradable digital forms of money, allowing the person to send or receive the money from the other party without any help of the third party service.read more bandwagon. Some traders use market timingMarket TimingMarket timing is the plan of buying and selling the securities on the basis of decisions made by financial investors. They do security analysis to earn a profit on selling and it is the action plan to cope up with the fluctuations in the market prices.read more strategies to get off the bandwagon after making substantial gains, and other sections of traders are affected by the highly volatile nature of cryptocurrencies.

Frequently Asked Questions (FAQs)

What is the meaning of hot hands?

It refers to the individual’s belief that a series of successful results will generate further success. For example, if a company’s stock price has been continuously moving upward for the past 20 days, it is easy for an investor to believe that it will continue to rise in the next few days.

Is there such a thing as a hot hand?

There is no convincing empirical evidence to back up its existence. It is classified as a behavioral bias, similar to extrapolation or recency bias, which causes people to make inaccurate forecasts. People make guesses about the randomized events based on their prior performance, which may or may not be correct. They will continue to believe in the notion if it turns out to be true.

Is the hot hand real in basketball?

The academics Thomas Gilovich, Robert Vallone, and Amos Tversky investigated the validity of hot hands in basketball. The result was explained in the cognitive psychology article “The Hot Hand in Basketball: On the Misperception of Random Sequences.” The article inclined with the absence of a positive correlation between the results of successive shots.

This has been a guide to what is Hot Hand and its Meaning. Here we discuss hot hand in investing and detailed explanations along with examples. You may also learn more about financing from the following articles –

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