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

66 Pages Posted: 2 Aug 2007

See all articles by Matthew Rabin

Matthew Rabin

University of California, Berkeley - Department of Economics

Dimitri Vayanos

London School of Economics; Center for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

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Date Written: February 2007

Abstract

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. We explore several applications, showing, for example, that investors may move assets too much in and out of mutual funds, and exaggerate the value of financial information and expertise.

Keywords: Behavioural finance, gambler's fallacy, hot-hand fallacy

Suggested Citation

Rabin, Matthew and Vayanos, Dimitri, The Gambler's and Hot-Hand Fallacies: Theory and Applications (February 2007). CEPR Discussion Paper No. 6081, Available at SSRN: https://ssrn.com/abstract=1004563

Matthew Rabin (Contact Author)

University of California, Berkeley - Department of Economics ( email )

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Dimitri Vayanos

London School of Economics ( email )

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Center for Economic Policy Research (CEPR)

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National Bureau of Economic Research (NBER)

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