So what should you do as a financial professional? With respect to the hot hand fallacy, it is important to get clients to focus on the bigger market picture and not just what has been happening in markets recently. One tip would be to provide clients with a deeper historical perspective, using the base rate data. A few weeks, months, or quarters of statistics and price information may not be sufficient. Providing a fuller picture of the historical value of an asset can be helpful. In addition, reminding clients to plan and schedule rebalancing of their portfolios can also eliminate the opportunity for them want to buy or sell rashly based upon very recent market trends.

Financial professionals are generally not as susceptible to the hot hand fallacy with regard to financial markets. You are trained to monitor markets in order to provide the best possible advice to clients. However, this familiarity with historical market data can lead you to be influenced by another type of bias called the gambler's fallacy. The gambler's fallacy is the tendency to overweight the probability of an event because it has not recently occurred. The gambler's fallacy can lead individuals familiar with base rate market information to view long streaks as being unlikely. You may feel that a recent run-up in the price of a stock is not consistent with the actual historical distribution. Thus, you may be overly prone to predict reversals in stock prices.

Using brain mapping experiments, researchers have found neurological-based evidence of the gambler's fallacy. One study found that individuals evaluate random events such that they overweight the probability of an event, if it has not recently occurred.⁴ In field experiments, Croson and Sundali observed that casino roulette wheel gamblers bet in accordance with the gambler's fallacy.² For example, if black had not come up in a while on the roulette wheel, bettors would think that black was due to come up and would bet more on black. Making assessments based on a limited sample size like this leads to the gambler's fallacy. As a financial professional, when formulating investment advice, you need to keep the gambler's fallacy in mind so that you do not predict a trend reversal too quickly.

Both the hot hand fallacy and the gambler's fallacy belong to a group of biases that economists classify as "representative heuristics." (Heuristic is a fancy term for rule of thumb.) These heuristics involve making assessments based upon a small number of data points. Assuming that a small sample reflects the full distribution of outcomes in the same way that a large sample does, can lead to mistakes. In general, to avoid making these types of forecasting mistakes, it is important to take into account the size of the sample when drawing conclusions.

Key Takeaways

• The hot hand fallacy or extrapolation bias is the unwarranted extrapolation of past trends in forming forecasts.
• The gambler's fallacy is the tendency to overweight the probability of an event because it has not recently occurred.
• While clients are often more influenced by the hot hand fallacy, financial professionals need to be more aware of the gambler's fallacy and its effects on their advice.
• With respect to the hot hand fallacy, when advising clients it is important to get them to focus on more complete market data and not just recent market trends.
• When developing investment advice for a client, keeping the gambler's fallacy in mind can decrease the tendency to overweight the probability of an event because it has not recently occurred.