The Hot-Hand Fallacy — The Illusion of Streaks, and the Twist

The Hot-Hand Fallacy refers to the illusion that, when a run of successes occurs in a near-random process, 'you're on a hot streak, so you'll keep succeeding.'

The starting point is the basketball-shooting study published by psychologists Gilovich, Vallone, and Tversky in 1985. Analyzing players' shooting records, they found no evidence that 'the success rate is higher after consecutive makes,' and concluded that the 'hot hand' was an illusion where people misread random streaks.

But in 2018–2019, economists Miller and Sanjurjo showed that the original analysis had a subtle statistical bias. The very way of counting 'the frequency of a success after a success' in short sequences had a bias that pushed the value lower.

When this bias was corrected and the original data re-analyzed, traces of a hot hand actually appeared. It was reported that 19 of 25 players had a higher success rate after three consecutive makes. In other words, the weight shifted toward the view that a slight 'real streak' can exist in sports.

A basketball may have a physical continuity of fingertip condition, but investment returns have far weaker grounds for that. Concluding that a fund or stock that did well for the past few years 'is on a streak, so it will keep doing well' is dangerous.

In fact, people repeatedly pile belatedly into products that had good performance, only to take the full drawdown as the streak breaks. A short run of successes could be skill or could be luck. Distinguishing them requires a sufficiently long period and a large sample, and above all you must look at the maximum drawdown and the duration of losses along that path.