Human brain is a pattern seeking machine. When we see something that looks like order we usually attribute it to human intelligence and skill. Hot hand fallacy is a proof of how easily we get fooled by randomness.
One of the most embarrassing moments in my childhood days was when my class teacher asked me something about Sachin Tendulkar. I replied, “Who is Sachin Tendulkar?” It was 1992 and I was in 6th standard. The whole class, including the teacher, burst into laughter. That was the day when I started taking active interest in cricket. Of course the motivation was to avoid looking like a fool in a cricket crazy nation.
“Dravid is not in form these days,” claimed one of my friends.
“I hope he comes back in form soon else he will be dropped from the national team,” argued another friend.
I nodded in agreement. I was faking. Because one thing that still baffled me was the idea of a player being “in-form” or “out-of-form.”
“What’s this in-form and out-of-form business?” I asked my best friend. He was the only who I didn’t feel the need to impress with my cricket knowledge.
“Well, if a player plays consistently well for many innings, he’s said to be in good form. Otherwise he’s considered as out of form,” he explained. “An in-form player is always in demand because he’s expected to continue playing well.”
Why does an in-form player play well? The form was based on his past performance so how does that ensure his future performance? Isn’t this form business based on a circular logic?
These were some intelligent questions that I should have asked from my best friend but I wasn’t really very inquisitive as a child so I left it that.
[show_to accesslevel=’almanack’] This whole idea of “form” isn’t unique to Indian cricket scene. In fact, it exists in every country in the world where competitive sports are played and followed seriously. And as always, psychologists have a strong reason to believe that it’s a cognitive bias. They have named it the Hot Hand Fallacy.
Hot Hand and Randomness
Hot hand effect is the deeply ingrained belief that certain sportsmen can, at certain times, demonstrate a “hot streak,” in which they defy all normal levels of skill to demonstrate an above average performance at will. Psychologists believe that this is nothing more than the all-too-human tendency to see order in random patterns, plus the impact of recency, as we just look at the recent results and ignore the long-term trends.
By no means I am implying that performance of legendary sportsmen like Rahul Dravid and Sachin Tendulkar is attributed to hot hand effect. These players have played cricket extremely well for decades. However, when someone pigeonholes into the short term track records (few months or handful of matches) to pronounce a player being “in-form”, it’s clearly the case of hot hand fallacy.
The main culprit here is human brain’s inability to differentiate between what’s truly random and what’s not. To illustrate this, let me take an example. Following four sequences represent the result of coin tosses. ‘T’ represents tails and ‘H’ is heads. Some of these four sets were generated by tossing a real coin and rest were faked. Can you tell which one is a truly random sequence and which one isn’t?
1. T H H H H T T T H H H H T T T H
2. H T T T T T T T H T H T H T H H
3. H T T T T T H T T H T T T H H H
4. T H H T T H T H T H T H T H H T
To most people, second and the third sets look fake. After all, a coin has a 50-50 chance of turning up heads/tails. Getting 7-8 consecutive tails in a sequence of 16 tosses doesn’t look real. Truth is, in a really big, really random set of coin tosses you’d find sequences of hundreds of successive heads or tails. No wonder, the correct answer for the above riddle is option 4. If you go by intuition, option 4 looks perfectly random, but it isn’t. It’s the fake one. You’ve been fooled by randomness.
Nassim Nicholas Taleb, in his book Fooled by Randomness, argues –
The ‘hot hand in basketball’ is another example of misperception of random sequences: It is very likely in a large sample of players for one of them to have an inordinately lengthy lucky streak. As a matter of fact it is very unlikely that an unspecified player somewhere doesn’t have an inordinately lengthy lucky streak. This is a manifestation of the mechanism called regression to the mean….in real life, the larger the deviation from the norm, the larger the probability of it coming from luck rather than skills…This can be easily verified in stories of very prominent people in trading rapidly reverting to obscurity, like the heroes I used to watch in trading rooms.
It’s said for deeper understanding of an idea, you should be aware of opposing argument too. Hot hand fallacy is actually the reverse of Gambler’s Fallacy which we wrote sometime back in Latticework series.
One of the arguments supporting hot hand fallacy goes something like this – a winning streak promotes self-confidence which in turn increases the concentration and mental sharpness of the player resulting an improved performance in future. That’s a reasonable argument. Many professional players accept having experienced the intense state of flow under which even the cricket ball looks the size of a football to the batsman. When a player is in such a ‘zone’ he has much better odds of performing well. But one may also argue that a streak of winning performance puts enormous pressure on the player to continue performing well. As those high expectations build up, they may overwhelm the player and break the “flow state” of the player.
Hot hand effect isn’t just limited to realm of sports. Do you remember seeing animal faces in clouds?
The Face of Mars
Many researches have proven that infants as young as few weeks have the ability to recognize human faces. It’s a trait hardwired by evolution because it gave a survival advantage to early humans (our ancestors who lived as hunter gatherers few thousand years before) to develop this ability to differentiate between the face of a fellow human and a dangerous animal. That’s why when a non-living entity resembles the features of human face, we can’t help but think that it was deliberately created by someone else. There’s a name for this human quirk. It’s called Pareidolia and it can cause people to interpret random images, or patterns of light and shadow, as faces.
The above photo is a satellite image of a rock on planet Mars. Doesn’t it resemble a human face? The image caused many to hypothesize that it was the work of an extra-terrestrial civilization. Later images revealed that it was a mundane feature rendered face-like by the angle of the Sun. Fooled by randomness, again!
Tim Richards, in his book Investing Psychology, writes –
In general, the world is a disorderly place, full of random events. We’re attuned to look for cause and effect because where we find order we generally find human beings at work, turning the randomness of the world into something less perplexing. So, order is a sign of some kind of a directing mind, someone in control and, in the main, that someone is another human being. Of course, where there is apparent order, which couldn’t have been created by humans—such as the so-called face of Mars—some people leap to the conclusion that we’re looking at the work of alien intelligence, rather than reaching for the more prosaic explanation of pareidolia.
Moreover, a human brain cannot store an information if it can’t make sense of it. A pattern facilitates a compelling story for our brains. And if the story doesn’t exist, our brains makes one up, albeit a false one, a pareidolia.
Skill Vs Luck
It’s not that all patterns are bad. Many legendary sportsmen have performed consistently well for decades and that’s a strong evidence of their skills. So how do we separate the patterns prone to hot hand fallacy from the ones which are not?
One key differentiating factor is the time horizon over which a pattern is observed. A pattern which is visible over a short term isn’t much reliable. The second factor is the element of luck present in an activity. In any activity (including sports, investing, etc.), the outcome is governed by a combination of both skill and luck. However, the proportion of each, skill or luck, are different for different activities. So for a game like chess, skill plays are large role and effect of luck is almost negligible. Whereas in activity like investing, luck plays a crucial role.
This irresistible urge to seek patterns can get us into serious trouble when we take this tendency to field of finance and investing. So as an investor, it’s important to know that we’re dealing with something where randomness and chance can distort the expected outcome in short term.
Recency bias is another cognitive bias which reinforces the hot hand effect in investing. Recency is when we are over influenced by recent events. Tim writes –
Unfortunately, recency means that we only tend to look at the most recent events in a long sequence, those which are available to our brains, which means we can be fooled into thinking we’re looking at the results of skill and intelligence when actually all we’re seeing is a snapshot of a small sequence of the output of a coin tossing machine.
And one effect of recency is the idea that stocks can demonstrate “hot streaks.” Investors have a tendency to extrapolate the recent market behaviour to the future, i.e. they believe that a stock which is in-form will continue to perform well and an out-of-form stock will stay depressed. This is a dangerous conclusion especially because investors are usually focussed on the recent stock price trends.
Same is true when it comes to evaluating the performance of fund managers. It’s quite possible that a fund’s recent short term performance is purely random and has very less to do with the investment manager’s skills but when we see something that looks like order we usually attribute it to human intelligence and skill. Hot hand fallacy is another reason why one should look at the long term results of business while evaluating a stock. Last few quarter results, even with a clear pattern, don’t reveal any useful insights. Focusing on 10 years of financials and business performance reduces the odds of getting fooled by hot hand effect.
Market extremes (bull and bear markets) is nothing but the result of a strong belief in hot hand effect. When the broader market starts rising, which could totally be a random fluctuation, it creates an illusion that something must be good about economy and business environment in general. People start inventing reasons to explain the short term patterns, which strengthens their belief further and quickly market can get on a roll for reason that have nothing to do with the true valuation of the underlying securities.
Time and again it has been proved that majority of stock price changes are nothing more than random jitters in the system for which no explanation is ever required — yet you can find people obsessing over every miniscule movement and explaining them in terms of some causal event.
In the end, hot hand fallacy is a lollapalooza outcome of pareidolia, illusory pattern recognition, availability, and recency bias. Tim Richards summarises it well –
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The hot-hands effect is caused by only looking at a small snapshot of a much longer sequence of data. It’s an example of recency, where we are biased by the latest available information. Try to look at the bigger picture: don’t expect an average slugger to keep on hitting home runs, and don’t expect a biased investor to even make average returns.
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