Do Sophisticated Investors Believe in the Law of Small Numbers?

40 Pages Posted: 5 Mar 2008

See all articles by Guillermo Baquero

Guillermo Baquero

ESMT European School of Management and Technology

Marno Verbeek

Erasmus University - Rotterdam School of Management; Erasmus Research Institute of Management (ERIM); Netspar

Date Written: January 20, 2007

Abstract

Believers in the law of small numbers tend to overinfer the outcome of a random process after a small series of observations. They believe that small samples replicate the probability distribution properties of the population. We provide empirical evidence indicating that investors are mistakenly driven by this psychological bias when hiring or firing a fund manager. Using quarterly data between 1994 and 2000 of 752 hedge funds, we look at investment and divestment decisions of investors after a successful (or losing) streak of a fund manager. Apparently, sophisticated investors exhibit a "hot-hand" bias that may seriously harm their wealth.

Keywords: Law of small numbers, performance persistence, overreaction, hedge fund investors, hot-hand bias

JEL Classification: G11, G14, G23

Suggested Citation

Baquero, Guillermo and Verbeek, Marno, Do Sophisticated Investors Believe in the Law of Small Numbers? (January 20, 2007). AFA 2007 Chicago Meetings Paper; EFA 2008 Athens Meetings Paper. Available at SSRN: https://ssrn.com/abstract=891309 or http://dx.doi.org/10.2139/ssrn.891309

Guillermo Baquero (Contact Author)

ESMT European School of Management and Technology ( email )

Schlossplatz 1
10117 Berlin
Germany

Marno Verbeek

Erasmus University - Rotterdam School of Management ( email )

P.O. Box 1738
Room T09-53
3000 DR Rotterdam
Netherlands
+31 10 408 2790 (Phone)

HOME PAGE: http://www.rsm.nl/mverbeek

Erasmus Research Institute of Management (ERIM)

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Netspar

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

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