Posted on August 17, 2020
Whether you’re watching sports or deciding on which firm to invest your money with, knowing about the gambler’s fallacy and the hot hand effect can save you from making a false analysis. Depending on the situation, this can save your time, money, and reputation.
The Hot Hand Effect
Take these two scenarios for example…
1. The professional basketball player hits their fifth 3-pointer in a row.
2. An investment firm has 10% growth each quarter for two years.
You may believe that the performances in both cases will continue because of their successes; that they’re more likely to do better in subsequent attempts because they’ve already been doing well.
“Our teammate is hot right now! They’re going to keep hitting these shots, so we’d better keep passing them the ball.”
“I’m going to invest with this firm. They’ve been so successful over the past two years, they obviously know how the markets work.”
Assuming this is a logical fallacy. These analyses are examples of the “hot hand effect”. Simply because someone has done well in the past doesn’t mean they will continue to do so.
The Gambler’s Fallacy
The gambler’s fallacy is the exact opposite of the hot hand effect.
You’ve certainly interacted with, or maybe even believed in the gambler’s fallacy. This fallacy says that after a string of a certain outcome, the opposite is more likely to happen.
For example, you flip a coin five times and each outcome is heads. Is it more likely that your next flip will be tails to “even it out”? No – the former events have no bearing on the next outcome, just like in the hot hand example above.
This can be especially dangerous if you’re playing a betting game, such as roulette – just because the ball has landed on black for the past five rolls doesn’t mean you should put it all on red.
The Representativeness Heuristic
The main psychology behind the gamblers fallacy and the hot hand effect is the representativeness heuristic. The representativeness heuristic is a fancy way to say “if something sounds like a good description, we are more prone to believe it.”
Humans naturally gravitate towards narratives. We love it when events in the world are explained by simple stories. Unfortunately, the world doesn’t always fit into our nice narrative structures. The more cognizant we are of this fact, the better our analyses will be.
If this topic interests you, I suggest checking out Thinking Fast and Slow by Daniel Kahneman. The book highlights the many interesting parts of behavioral psychology and economics.