Hot-hand fallacy

Hot-hand fallacy is the belief that a successful streak in recent performance predicts continued success in the immediate future. A fund manager beats the market for three years, and the fallacy says she will beat it in the fourth year. A stock has risen 15% in the past month, and the fallacy says it will continue rising. In reality, past success does not predict future success; in fact, extreme past performance is often followed by reversion to average.

The mechanism

Hot-hand fallacy arises from:

Representativeness. A manager with three years of outperformance looks like a “successful manager.” This representativeness of success makes us believe success will continue.

Availability and recency. The recent successes are vivid and available. They loom large in memory, making continued success seem likely.

Failure to account for regression to the mean. Extreme past performance often involves luck. Regression to the mean says the performance is likely to revert to a more average level, not to continue at the extreme.

Hot-hand fallacy in practice

Fund chasing. Investors chase funds with recent strong performance. A fund outperforms 15% in a year, and the investor buys. But studies show past performance of funds does not predict future performance. The investor bought at a peak, right when the hot hand is cooling.

Stock momentum. A stock has risen 20% in three months. The investor, seeing the hot hand, buys. But momentum is not a reliable predictor of future returns. The stock might reverse or consolidate. The investor bought because of past performance, not because of changed fundamentals or valuation.

Manager persistence. A manager beats the market for five years. The hot-hand fallacy says she will beat it in the next five years. But research shows that manager outperformance does not persist. The five-year winner is no more likely to outperform next year than a randomly selected manager.

Hot-hand fallacy vs. momentum effect

There is a real phenomenon called momentum: stocks that have recently outperformed tend to continue outperforming, at least in the short term (a few months). This seems to contradict the claim that hot-hand is a fallacy.

But momentum is typically weak and often disappears after trading costs. More importantly, momentum is a market anomaly — it should not exist if markets are efficient. It is not a reliable strategy for individual investors. Believing in momentum and using it to trade is hot-hand fallacy.

Hot-hand fallacy and overconfidence

Hot-hand fallacy pairs with overconfidence bias to create dangerous decisions. An investor sees a successful fund and, suffering from hot-hand fallacy, believes future success is likely. Suffering from overconfidence, she believes she can identify which successful funds will continue to succeed. Together, these biases drive her to overweight recent winners, just as they peak.

Hot-hand fallacy and confirmation bias

An investor buys a hot stock and then suffers from confirmation bias, seeking confirming evidence that it will continue to rise. Each day of continued outperformance reinforces the hot-hand belief, locking her in until the reversal is severe.

Defenses against hot-hand fallacy

• Do not chase recent performance. A fund or stock that has recently outperformed is likely near a peak. Resist the urge to buy it.
• Use a decision framework independent of past performance. Choose funds based on diversification, fees, and fundamentals. Do not choose based on recent returns.
• Track past performance predictions. Which funds did you think were “hot” and likely to continue outperforming? Track their subsequent performance. You will find they underperformed.
• Use index funds. An index fund eliminates the need to pick managers or chase performance. It guarantees market returns (minus a small fee).
• Remember: past performance is not predictive. This is true. Do not let recent hot hands trick you.

See also