Hot Hand

A hot hand is a common belief of attracting success by past successful performance. Typically, it’s used as a fixed expression “to have a hot hand”, which refers to a person, company, or other entity that gains luck lately. Gamblers, traders, and businessmen are frequently seen as people who are more susceptible to this belief.

Let’s consider the following abstract example. If you play a game and win several times in a row, someone might say that you have a hot hand, meaning that it’s quite likely that you’ll win again in the next game. The hot hand makes you (and sometimes others) believe that your chances of winning are more than they actually are.

There is also an opposite belief called a cold hand. Basically, it has the same meaning as the hot hand, except for the continual success. Instead of it, a person suffers from a series of failures and believes that he or she is unable to reach great results.

Hot Hand: truth or bias

Psychologists consider the hot hand phenomenon as a type of heuristic techniques, or people’s prepossession towards quick and easy decisions. Sometimes, we tend to solve problems by jumping to conclusions. These decisions might be quite subjective because they are often based on previous experience, random analogies, or other unproven assumptions.

Traders’ decisions in relation to these heuristic techniques are analyzed by the behavioral economics. Among other heuristics, the hot hand is closer to the representativeness. This mental bias refers to the fact that people tend to make conclusions based on their observations rather than facts. For example, one company has successfully expanded its business to another country. An investor notices this fact, and makes a conclusion that it was a profitable move. Then he finds information that a similar company attempts to make the same expansion and automatically concludes that it’s a profitable move as well. Consequently, it’s reasonable to invest in this company. However, the investor’s decision is based only on the previous observations instead of the company’s actual characteristics.

The psychological point of view is still considered to be controversial. While some research prove it, there are others that contradict it. For example, the influence of the hot hand phenomenon within the sport betting industry has been proved to be real, not biased.

Disadvantages of the Hot Hand

The main disadvantage of the hot hand in terms of investing is that it contains a lot of risks for investors. If we consider this phenomenon as a psychological bias, it’s more likely to lead investors to some hasty decisions which might endanger their investments. It may happen differently:

• An investor might choose a fund to invest in according to its recent success. The fund’s previous performance is important for analysis, but the whole analysis can’t be based on this characteristic only. If the investor is guided by the idea of the hot hand, he’ll put his investments at risk. The company’s recent success might be just a coincidence.
• The investor might make ill-considered investment decisions, believing that he has the hot hand and success is guaranteed. He might take unreasonable risks, which won’t be paid off later.
• The investor is ensured that he has the hot hand and eager to make some risky investment moves. Let’s suppose that the risk gets paid off, thereby proving the hot hand phenomenon for the investor. He continues to use the risky strategy of investing, gaining more self-confidence and probably arising another biases such as illusion of control or hindsight bias. When a person is confident of success, he or she tends to take less attention to the details and full analysis. Sooner or later, this tendency might lead the investor to losses of investments.