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

66 Pages Posted: 3 Jan 2007 Last revised: 19 Oct 2009

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 28, 2009

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. 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.

Keywords: Gambler's fallacy, Hot-hand fallacy, Dynamic inference, Behavioral Finance

JEL Classification: D8, G1

Suggested Citation

Rabin, Matthew and Vayanos, Dimitri, The Gambler's and Hot-Hand Fallacies: Theory and Applications (February 28, 2009). AFA 2010 Atlanta Meetings Paper. Available at SSRN: https://ssrn.com/abstract=954636 or http://dx.doi.org/10.2139/ssrn.954636

Matthew Rabin

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

549 Evans Hall #3880
Berkeley, CA 94720-3880
United States

Dimitri Vayanos (Contact Author)

London School of Economics ( email )

A350
Houghton Street
London WC2A 2AE
United Kingdom
+44 (0)20 7955 6382 (Phone)
+44 (0)20 7955 7420 (Fax)

Center for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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