Journal Article

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

Matthew Rabin and Dimitri Vayanos

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 77, issue 2, pages 730-778
Published in print April 2010 | ISSN: 0034-6527
Published online April 2010 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/j.1467-937X.2009.00582.x
The Gambler's and Hot-Hand Fallacies: Theory and Applications

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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 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. Our model has implications for a number of puzzles in finance, e.g. the active-fund and fund-flow puzzles, and the presence of momentum and reversal in asset returns.

Journal Article.  20075 words.  Illustrated.

Subjects: Economics

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