Inference from Streaks in Random Outcomes: Experimental Evidence on Beliefs in Regime-Shifting and the Law of Small Numbers

Posted: 12 Jun 2009

See all articles by Elena N. Asparouhova

Elena N. Asparouhova

University of Utah - David Eccles School of Business

Michael G. Hertzel

Arizona State University (ASU) - Finance Department

Michael L. Lemmon

University of Utah - Department of Finance

Date Written: June 10, 2009

Abstract

Using data generated from laboratory experiments, we test and compare the empirical accuracy of two models that focus on judgment errors associated with processing information from random sequences. We test for regime-shifting beliefs of the type theorized in Barberis, Shleifer, and Vishny (1998) (BSV) and for beliefs in the "law of small numbers" as modeled in Rabin (2002). In our experiments, we show subjects randomly generated sequences of binary outcomes and ask them to provide probability assessments of the direction of the next outcome. Inconsistent with regime-shifting beliefs, we find that subjects are not more likely to predict that the current streak will continue the longer the streak. Instead, consistent with Rabin, subjects are more likely to expect a reversal following short streaks and continuation after long streaks. Results of a "test of fit'' analysis based on structural estimation of each model also favor the model in Rabin. To provide more insight on Rabin, we use an additional experimental treatment to show that as the perception of the randomness of the outcome-generating process increases, subjects are more likely to predict reversals of current streaks.

Keywords: decision making, experiments, prediction task, law of small numbers, regime-shifting

JEL Classification: G11, D8

Suggested Citation

Asparouhova, Elena N. and Hertzel, Michael G. and Lemmon, Michael L., Inference from Streaks in Random Outcomes: Experimental Evidence on Beliefs in Regime-Shifting and the Law of Small Numbers (June 10, 2009). Available at SSRN: https://ssrn.com/abstract=1418119

Elena N. Asparouhova (Contact Author)

University of Utah - David Eccles School of Business ( email )

1645 E Campus Center Dr
Salt Lake City, UT 84112-9303
United States

Michael G. Hertzel

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
P.O. Box 873906
Tempe, AZ 85287-3906
United States
480-965-6869 (Phone)
602-965-8539 (Fax)

Michael L. Lemmon

University of Utah - Department of Finance ( email )

David Eccles School of Business
Salt Lake City, UT 84112
United States
801-585-5210 (Phone)
801-581-7214 (Fax)

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